Last Friday, Bank of America and Jeff Gundlach opened a can of worms when they pointed out two things: i) that the Fed had not yet bought a single corporate bond under its month-old Secondary Market Corporate Credit Facility and ii) that it's time for the Fed to start buying, with Bank of America going so far as to write a "note to the Fed" in which its credit strategists wrote that "a lot of investors (including non-credit ones) have bought IG corporate bonds the past two months on the expectation they can sell to you. So would be helpful if you soon began buying broadly and in size."
The very next work day, the Fed responded, when on Monday morning the New York Fed - in response to the rhetorical goading by the bond king and one of the top US banks - provided an updated FAQ for the Primary Market Corporate Credit Facility (PMCCF) and Secondary Market Corporate Credit Facility (SMCCF).
As we reported yesterday, the most important update was that the Fed expects to begin purchasing ETFs in "early May", obviously means any day now. Commenting on this latest development, BofA - which started the ripple effect that eventually forced the Fed to chime in - said that it considers the Fed's announcement "to be a major step forward as some investors were beginning to wonder if, given improved market conditions, the Fed would ever need to implement the PMCCF and SMCCF." Because while Draghi could get away with "whatever it takes" as a perpetual threat, for the Fed to successfully unclog markets it would need to get its hands dirty. Separately, the Fed also stated that the PMCCF will be operational, and they will begin buying individual corporate bonds under the SMCCF, shortly thereafter.
And while Bank of America thinks that overall these plans are encouraging for corporate bond spreads, "the bad news is that the Fed left outstanding requirements for issuers to make certain certifications to be eligible even under the SMCCF." adding that in its view "this is the Achilles' heel of the SMCCF and the most difficult topic for the Fed to tackle."
Taking a step back, and reverting to its lecturing posture of what the Fed should and shouldn't do, BofA then writes that the Fed - like the ECB - "should take a broad portfolio approach to buying corporate bonds under the SMCCF." Admitting that there are "bound to make mistakes - all investors do including the ECB (Steinhoff), in a broad portfolio these will not be material. After all the Fed will already be buying ETFs and thus ineligible bank bonds, long maturities and companies receiving loans under the Cares act and some that have conflicts of interest. Not to mention the Fed will own debt in companies that will soon restructure and end up holding post-petition equity. What happens then, and will the Fed merely sell of its equity stakes? Nobody knows, because nobody can even consider a world just 3 months into the future where central planning has taken over markets which are now administered policy tools on behalf of the Fed and Treasury. To this, all BofA has to add is "start with conservative, but broad, criteria and have a process for companies to opt in if they feel unfairly left out. If you make a mistake, stop buying and sell."
In short, BofA reeeeeally wants the Fed to buy "broadly and in size" as it said last Friday.
There was some more bad news, however, because as BofA credit analyst Hans Mikkelsen calculates, in terms of ETFs, "we have estimated the Fed has capacity to buy about $28b of IG and $8bn of HY ETFs given they will only buy up to 20% of each fund." As Mikkelsen then adds, this small size is the reason ETF buying in itself is underwhelming. The Fed's updated FAQ also specifies that it will only pay a premium over NAV...
... of the lesser of 1%, or the standard deviation of daily premiums over the past 52 weeks.
It's not just BofA that was let down by the Fed's announcement. In a note from Goldman's Lotfi Karoui, he agrees with BofA that the ETF buying facility may end up disappointing far more people noting that "the Fed reiterated that the burden is on issuers to make the first move regarding participation in the programs. Eligible Issuers under the PMCCF and SMCCF will be required to certify compliance with the eligibility criteria (the requirements and processes for certification are under development and will be provided in the near future)", and then concluding that the "guidance on ETF pricing suggests the Fed is focused on market liquidity, and will not be buying ETFs at a premium" to avoid overpayment for an ETF relative to the cost of purchasing its underlying assets, and avoiding contributing to elevated demand that an ETF may already be experiencing.
Goldman then turned outright gloomy:
The additional information – specifically the focus on funding backstops and market liquidity – supports our view that the Fed is adopting a posture of “lender of last resort” to non-financial corporations, as opposed to a regular (and relatively sizable) market participant with a predictable flow of purchases like the ECB or the BoE. In our view, this is a different outcome than what most market participants priced in after the March 23 and April 9 announcements. This, combined with a backdrop of heavy new issue activity, leaves us comfortable with our view that the case for further spread tightening in the USD IG market is weak at the current juncture. That said, we still do not expect USD IG spreads to revisit the March wides.
In short, while the market still has the impression that the Fed's ETF buying will kick in as an "automatic stabilizer" during the next crisis, the reality may be that the bond ETF complex may very soon tumble as traders test just how real is the Fed's resolve to stabilize the bond market.
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In conclusion, a disappointed Bank of America writes that as "a result, expect most if not all ETF premiums to converge close to those values, thus further limiting the Fed's ability to buy in size in all but the most adverse scenarios, which will likely prove self-defeating as during the next crash, traders will do everything in their power to accelerate the drop to force the Fed to go all in and start buying stocks."