Lend Early and Freely
Why the Fed has intervened in corporate credit markets
Walter Bagehot famously advised central banks seeking to avert panic to “lend early and freely, to solvent firms, against good collateral, and at high rates.” The Federal Reserve has been attempting to follow Bagehot’s counsel to prevent the current public health crisis from turning into a financial crisis.
But since the last crisis, bank lending has shrunk from 30% of corporate lending to 22% of corporate lending while the bond market has grown from 55% to 65%.
Figure 1: Lending Growth Has Been Outside of the Banks
Source: Bloomberg Barclays Indices, FRED, S&P LCD via public sources, Preqin via public sources, Verdad analysis and estimates
To unfreeze frozen lending markets, the Fed is targeting corporate bonds, an unprecedented move. On March 23, the Fed launched two corporate credit facilities that allow the central bank to either lend directly to investment-grade corporations or buy their debt in the secondary market. The total size of the facilities is $750 billion, which is 13% of the $5.7 trillion investment-grade market. On April 9, the Fed expanded these two facilities to include bonds that were investment-grade before March 22 but were downgraded thereafter.
The Fed’s goal in targeting BB credits was to address the ongoing worry of a major dislocation if large amounts of BBB bonds, the lowest rung of investment grade, were downgraded to high yield (BB and below), which is why the direct purchase facilities are limited to these fallen angels. It is easier to see why they did this when looking at the distribution of corporate credit across investment grade and high yield.
Figure 2: BBB Debt is Bigger Than All of the High-Yield Market
Source: Bloomberg Barclays Indices, S&P LCD via public sources, Preqin via public sources, Verdad analysis and estimates. As of December 31, 2019.
The Fed also announced that these facilities could buy up to 20% of outstanding investment-grade ETFs and up to 20% of high-yield ETFs. This action was well received by the credit markets. Below we show the reaction of the largest investment-grade bond ETF, LQD, and the largest high-yield bond ETF, HYG. On the day of the first announcement, LQD jumped 7.3%. On the day of the second announcement, HYG jumped 6.5%.
Figure 3: Investment-Grade and High-Yield Price Jumps on Fed Action
Source: Bloomberg
Critics have attacked the Fed’s decision, citing these massive price movements as evidence that the central bank has “bailed out” risky borrowers and created significant moral hazard. The substantial rally in corporate credit—and the recent new issuances by firms like Marriott—are the direct result of the Fed’s announcements. A recent bulletin on bond distress and ETFs from the Bank of International Settlements found that “information flows from ETF prices to NAVs [bond prices], not vice versa.” In other words, we feel that ETF purchases can support the rest of the bond market.
The Fed’s actions have had the desired effect: unfreezing lending markets with an announcement. They used innovative and novel methods to achieve this goal, targeting corporate bonds and ETFs to properly address the new structure of the corporate lending market.
Though these actions have caused rallies in all forms of risky credit, these are second-order impacts. The Fed is not buying the riskiest products in corporate lending: B or CCC credit, CLOs, leveraged loans, or private credit. Nor have they bought the equities in leveraged companies. Perhaps such actions will follow if corporate lending markets freeze up again, but so far, the Fed seems to have achieved its goals with a targeted intervention into relatively high-quality corporate bonds.