All Eyes Are on Fed's Corporate Bond Buying Scheme

One of the most powerful programs the Federal Reserve has announced during the Covid-19 crisis is its corporate bond buying program, formally called the Secondary Market Corporate Credit Facility. While the Fed's actual buying of corporate bonds and exchange-traded funds has been meager, announcements about the program have been especially market moving. Monday's release from the Fed giving some details about buying individual corporate bonds was no exception. Stocks surged that afternoon, finishing some 3.4% higher than the lows from that morning. So what can we expect from this program, what kinds of bonds should benefit, and is the Fed actually setting us up for disappointment? Let's dig in. The Fed Always Had to Come Through I was surprised by how many market observers questioned whether the Fed would ever follow-through with buying individual corporate bonds. Perhaps this was because of the long delay after first announcing it would start buying ETFs first, or perhaps just the fact that the Fed's buying was so slow as to imply buying individual bonds was unnecessary. However, the Fed was always going to follow-through. They can't be the crisis manager who cried wolf. Fed Chair Jerome Powell said as much in a telling exchange with Sen. Pat Toomey during Senate testimony on Tuesday. Whatever you think of Toomey's politics, he has above-average understanding of the Fed and markets, and his questions of Fed officials are similarly above-average. Toomey pressed the Chair on why the Fed needed to buy corporate bonds if credit markets were functioning well. Powell agreed they didn't need to beyond doing what we said we were going to do. Is the Fed About to Accelerate Purchases? In the same exchange, Toomey expressed concern that Fed bond buying could diminish price signals and that to follow-through with buying now would make it appear the Fed was targeting corporate bond spreads. I'm sure many readers are sympathetic with Toomey's point. I don't see us as wanting to run through the bond market like an elephant doing things and snuffing out price signals, Powell responded, later suggesting that the individual bond purchases would essentially replace their ETF purchases. Some might say that the Fed can't help but be an elephant in markets. Regardless, if we take Powell at his word on that point, it is hard to see the Fed accelerating bond buying now. It was also unclear what exactly Powell meant when he said individual bond buys would replace ETFs. He may not have meant that in a literal one-for-one sense. However I don't think he would have made this point at all if the intention was to buy dramatically more in the Secondary Market Corporate Credit Facility, or SMCCF, going forward. Over the last month, the Fed has bought approximately $5.5 billion in ETFs. The SMCCF is supposed to subset in September, and the total potential size of the program was $250 billion. Could the Fed step up buying somewhat over the next three months? Sure. But even if it was three or four times the pace of the prior month, it would wind up only buying a fraction of what was originally advertised. Bond Buying 'Index' Is Narrower Than for ETFs In Monday's press release, the Fed said that it had created its own index of bonds eligible for purchase, and intends on matching that index as it buys individual bonds. In practice this essentially means Blackrock will be running a private ETF for the Fed. It is worth noting that the types of bonds that will make up this index are much narrower than the available universe in ETFs. First, the individual bonds will all be investment grade. The ETFs can include junk bonds. Second, the individual bonds have to mature within five years. The ETFs the Fed was buying included all maturities. This is meaningful since longer-term bonds are more volatile than shorter-term bonds, all else being equal. Lastly, it won't be buying any financial institutions, which make up about a third of outstanding investment-grade corporate universe. Again, we don't know exactly how much in ETFs the Fed will keep buying. To the extent that the new individual bond buying replaces ETF buying, the Fed would effectively be trading up in quality and down in maturity. Put another way, each marginal dollar the Fed invests would be lower risk than what they have bought to date. Relative Price Signals Should Remain In-Tact Circling back to Toomey's point about price signals, the Fed's pseudo-passive buying strategy should have a very limited impact on relative spreads. My back-of-the-envelope estimate is that the Fed's index has about 1,400 eligible CUSIPs, or Committee on Uniform Securities Identification Procedure numbers. Since some of those will never come up for sale, they will almost certainly run the same sort of replication strategy Blackrock uses for its public ETFs. Even so, I'd expect them to own something like 800-1,000 line items, including at least some bonds from just about every issuer. With their buying that spread out, they will have almost no effect on relative prices, at least among the bonds that are eligible. The Fed's effect on overall corporate bond spreads on the other hand is substantial. I'm not sure the actual buying has mattered much to date. The impact of the Fed's potential buying power has essentially given buyers confidence that the Fed is safeguarding liquidity and market functioning. There's no doubt that without the Fed engendering this confidence, corporate bond spreads would be far wider. Market May Be Running Ahead of Itself The euphoria that followed the Fed's individual corporate announcement was puzzling to me. It suggests that the market expects this next phase of buying to be meaningfully larger than the previous phase. Even if the Fed goes from buying about $5 billion per month to $15 or $20 billion, that's an incredibly small amount in the scheme of the $8 trillion U.S. corporate bond market. It could definitely be that once the market finds out how little the Fed is actually buying, there will be disappointment. If that's the case, risk assets (including corporate bonds) may still perform well, but then it becomes much more dependent on good economic news. That leaves me a bit more cautious. Since the Monday rally, I've been reducing risk on the margins. In credit, I'm taking some profits on more cyclical ideas and plowing them back into either governments or less cyclical corporate stocks.

All Eyes Are on Fed's Corporate Bond Buying Scheme

But what can we expect from this program, what kinds of bonds should benefit, and is the Fed setting us up for disappointment?

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