During the 2008 financial crisis, the federal government agreed to bail out banks that were too big to fail. In the current crisis marked by gutted resilience to the shock of coronavirus, the government has decided to bail out companies of debatable creditworthiness with junk bonds.
The Federal Reserve’s March 23 announcement is a first. It created two new facilities to purchase up to $750 billion worth of debt in investment-grade and junk bonds, including bond exchange-traded funds. The two programs allow the Fed to start purchasing corporate debt either directly from companies or through ETFs that track broad indexes of the bonds. The Fed’s Secondary Market Corporate Credit Facilities, or SMCCF, is expected to begin purchasing ETFs in May.
“The promise alone seems to have achieved the aim of preventing the economic crisis from becoming a financial crisis, in which the flow of money becomes restricted, debt markets become less liquid, and the financial system seizes up,” Barrons reported.
One of the biggest areas of focus is in high-yield bonds. The Fed has said it will buy “fallen angel” companies — investment-grade companies that recently dropped into junk territory due to the coronavirus crisis.
Prominent fallen angels include Ford, Kraft Heinz and Occidental Petroleum, CNN reported. There were $101 billion worth of downgrades into junk territory during the first quarter, according to Fitch Ratings.
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The corporate facilities are among nine emergency Fed lending programs backed by a $2-trillion-plus economic relief package to help the U.S. economy during the coronavirus pandemic and keep credit flowing. “The move was a dramatic escalation of the central bank’s intervention, stepping into the corporate debt markets for the first time since the 1950s and including some sub-investment grade debt in the ETF purchases,” Bloomberg reported.
Some market participants see the Fed’s moves as a big opportunity. Critics say the Fed is overstepping its mandate by purchasing corporate bonds that will set a dangerous precedent and could be hard to undo when the crisis ends.
If the Fed buys the ETF, the ETF instrument will buy more of the corporate bonds directly that are in the ETF. The Fed doesn’t have to buy the junk debt directly because the exchange-traded funds will do it when they get their cash from the Fed. This eases financial conditions for corporate borrowing as the Fed is a backdoor borrower of junk debt.
The Federal Reserve Act prohibits the Fed from buying corporate assets. To get around that, the Fed is setting up a special purpose vehicle managed by BlackRock to do the buying. The central bank cited “unusual circumstances” that authorize the Fed to conduct “broad-based” lending facilities. “Still, the Fed will be the one calling the shots,” according to CNN.
“Many see this move by the Fed as a bailout for the wealthy — those at the top of the financial and investor class,” said Tunde Ogunlana, a family wealth advisor at securities and investment advisory service Axial Family Advisors.
The Fed’s new policy has winners and losers. Taxpayer will be the losers, Ogunlana said in an email to Moguldom. “This would be similar to someone who ran up a bunch of credit card debt due to poor decisions and mismanagement of their own finances, and the U.S. government rewarding that person by paying off their balances with our tax dollars.
“The winners would be the bank who issued the credit card along with the person who made poor decisions. The loser would be the taxpayer and future generations who will have a larger portion of the federal budget spent on interest payments on government debt instead of having those budget dollars allocated to investment in the future of the country (infrastructure, education, defense, preparing for future pandemics and natural disasters, etc).”
The Fed’s balance sheet has already ballooned to a record $6.7 trillion in the week ending April 29, up from $6.62 trillion in the previous week, Marketwatch reported. Analysts expect it will soon be at $10 trillion.
“There are legitimate reasons to help the bond market maintain liquidity behind the scenes,” Ogulana told Moguldom. “The financial ecosystem is interlocked and connected in similar ways as the natural ecosystem. A breakdown in one area can have very negative effects in other areas and, just as we see with the coronavirus, can spread quickly as a form of a ‘financial contagion’.
“However, the Fed’s intervention in the junk bond market marks an important moment in our economic history. This is not market capitalism. Contrary to the understanding of many, the U.S. economy has never been a 100-percent free market (most economies around the world are not). From the building of roads and bridges, the funding of police and fire departments, public schools, military and defense, the oversight of national parks, Social Security and Medicare… the U.S. has always had areas of the economy that could be defined as socialistic in nature.
“What has traditionally made the U.S. economy unique is that the socialistic behavior of the system has not permeated the business arena. Companies take risks, those with equity stakes take risks, those who lend to companies that take risks are also taking risks. For these risks, these investors and lenders are rewarded with the ability to make gains or their risks don’t work out and they suffer losses.
“They are also rewarded in areas such as favorable tax treatment on capital invested for taking the risk. This relationship of risk and reward as related to capital in the U.S. is one reason why our economy has dominated the global landscape for the past 100+ years.
“This relationship has allowed the U.S. to attract immigrants from around the world who share that dream of ownership and entrepreneurship. What the Fed has done by stepping into the junk bond market is to upset this order.
“By buying junk bonds, the Fed has said that it will bail out companies that the market deemed insovlent or mismanaged prior to the COVID-19 crisis.
“The Fed has basically announced that they will reward those who chose to invest and lend money to risky companies by using our tax dollars to buy their bonds,” Ogunlana said.
Listen to GHOGH with Jamarlin Martin | Episode 39: Tunde Ogunlana Jamarlin talks to family wealth advisor Tunde Ogunlana, CEO of Axial Family Advisors, about estate planning and Snoop Dogg’s comment that he doesn’t need a will (“I don’t give a f— when I’m dead. What am I gonna give a f— about?”). They also discuss the growing college debt bubble, whether more free tuition will help solve the problem, and why MBAs are like the bachelor’s degrees of 30 years ago.
Investors are excited about bond ETFs in anticipation of the Fed’s purchases, Bloomberg reported. The largest junk-debt ETF — BlackRock Inc.’s $20 billion iShares iBoxx High Yield Corporate Bond ETF — attracted a record monthly influx of $3.7 billion in April. The $46 billion iShares iBoxx $ Investment Grade Corporate Bond ETF rallied about 12 percent as of early May after the Fed first made the announcement in March.
It’s debatable whether or not this move by the Fed is a bailout for the wealthy — those at the top of the financial and investor class.
“The bigger question,” Ogunlana said, “is this: Do we want a system like this in the U.S. as it appears to resemble a form of socialism for the financial sector and capitalism for the rest of us?”