MNI EXCLUSIVE: Expanding Fed Corporate Bond Buys Won't Be Easy

The Fed could soon face pressure to buy more junk debt to forestall a wave of bankruptcies as the pandemic wears on, but concerns over moral hazard and lost independence may prove harder to overcome than in the first corporate bond program, former officials told MNI.

The U.S. central bank has so far managed to boost asset prices and ease borrowing costs by tapping just a fraction of its emergency lending capacity. But as the coronavirus continues to spread and fiscal aid in doubt, investors will lobby for greater support via the deployment of USD260 billion in unused Treasury funding earmarked for emergency Fed programs.

"If the economy is going to get worse, not better, over the next three quarters, or if they find that inflation is moving down, then that's when I think they will take forceful action" by scaling up QE and corporate bond buying, said Bill Nelson, former Fed deputy director of monetary affairs and current chief economist at the Bank Policy Institute.

"When the Fed decides to go for shock and awe, it will increase the size of these purchases. It could also extend eligibility to slightly-below-investment grade bonds as it has already done for its primary market purchases of corporate bonds."

WORKING SO FAR

One reason to expand the corporate bond program is that it's extremely effective. The Fed's promise alone to purchase corporate bonds on March 23 sparked a sharp rally in markets and opened the floodgates for new sales.

"Right on announcement, we saw a major relaxation of trading costs for eligible bonds," said Mahyar Kargar, an economist at the University of Illinois at Urbana-Champaign and co-author of a National Bureau of Economic Research working paper studying the unprecedented lending facility. "When the program was extended to fallen angels on April 9, liquidity conditions improved again," because bondholders felt assured they would always have a buyer in the central bank.

Some high-yield ETFs saw their largest one-day rally since 2008 on the news. High-yield spreads have narrowed by over 1,000 bps in late March to just under 475 bps this week, according to a Mizuho client note. Investment grade spreads have fallen to 128 bps from over 373 bps immediately after the Covid-19 lockdowns were implemented.

MORAL HAZARD

To date, the Fed has bought just USD12.6 billion of corporate bonds, well short of the USD750 billion capacity. Only 3% of its holdings are rated junk as of July 31, the latest data available.

"It's very remarkable that the credibility of their commitment was so powerful that private market participants did all the work. But what if private market participants become more skeptical?," said Kim Schoenholtz, an economist at New York University. That would force the Fed to purchase more bonds and riskier ones to stabilize spreads, he said.

TREASURY STEPPING IN