On 23 March 2020, the US Federal Reserve (Fed) launched the Secondary Market Corporate Credit Facility (SMCCF) — a special-purpose vehicle (SPV) designed to support the corporate-bond market in the face of the COVID-19 crisis. In late June, the Fed released an official list of its initial bond purchases made via this program.
The more I think about the Fed taking the unprecedented step of buying corporate bonds as part of its crisis-response arsenal, the more I believe it’s difficult to overstate the implications. Here are some of my latest thoughts on the matter.
Five thoughts on the program
In my view, the Fed’s corporate-bond-buying program:
- Minimizes tail funding risk. Many US corporate-bond issuers were distressed and deemed to be at risk of bankruptcy as recently as a few months ago. Then came the Fed’s bond-buying program, which is aimed at removing tail funding risk, primarily for corporates that “should” survive (based on their investment-grade ratings pre-COVID-19). The terms of the program have since been loosened considerably to ensure that it casts a sufficiently wide net.
- Won’t avert a credit cycle. How, some investors ask, can a vicious credit cycle occur if the Fed is essentially backstopping distressed issuers? The US Treasury has provided some capital to absorb potential losses. As noted, however, the Fed’s corporate-bond purchases will be concentrated mostly in investment-grade names. So, while the program should help dampen a credit/default cycle, it won’t entirely avert one (as the recent increase in high-yield defaults demonstrates).
- Favors some issuers over others. By its nature and parameters, the Fed’s corporate-bond-buying program favors bigger companies in the investment-grade space, as well as those that issue their bonds in the public-debt markets. However, the Fed is attempting to reduce the perceived “favoritism” by enlisting an external party — a large, well-known asset manager — to replicate a broad corporate-bond-market index.
- Helps boost the equity market. One effect of the Fed’s bond-buying program is to structurally lower the cost of capital for the chosen issuers, with a potentially positive impact on those companies’ equity values. In this sense, and also because the bond purchases should push investors further out the risk spectrum, I would argue that the program is just as important to the equity market as it is to the corporate-debt market.
- Could be expanded if need be. With the 2020 elections fast approaching, it’s worth noting that a different US administration could, theoretically, opt to not implement Section 13(3) of the Federal Reserve Act, which enabled creation of the Fed’s bond-buying program. In that case, the program could not be expanded. However, it’s hard to imagine the Fed — whose leadership won’t change in 2021 — not finding ways to act more boldly in the event of a worsening economy if COVID-19 resurges.
(Related investment idea: Investors seeking a portfolio hedge against the possibility of the Fed stepping in more aggressively might consider adding (or increasing) allocations to shorter-term investment-grade credit.)
Will it go temp-to-perm?
Although the Fed’s rhetoric suggests that its bond-buying program is temporary, many observers can’t help wondering if the stakes are simply too high this time around for the Fed to ever reverse course. Could this program, and others launched amid COVID-19, be perpetually extended?
The short answer is: I doubt it. According to Section 13(3), the new programs intended specifically to provide credit are allowed only under “unusual and exigent circumstances.” While there are always loopholes in these laws, bear in mind that the Fed is generally very uncomfortable with being an allocator of credit, even under normal conditions. Thus, I would expect the Fed to begin transitioning out of these programs as soon as it thinks practical without causing major disruptions to market functioning.