We are literally only a month or so into this crisis and the Fed has already played its 2008 crisis notebook and more. The Fed has resorted to a number of tactics to try to save the economy from falling off a Corona cliff. It has been steadily pumping money into markets in an effort to provide floors for prices and income for some furloughed workers. The main mechanisms they have used so far are:

• Buying Treasury securities and agency debt, meaning those securities issued by Fannie Mae, Freddie Mac and Ginnie Mae. These include both residential mortgage securities and commercial mortgage securities. This was already in the Fed’s remit so was not a surprise.
• The Fed will lend to Primary Dealers against collateral and has said that this collateral can essentially be anything. That can be corporate bonds, junk bonds, MBS or stocks. This combined with the above has created a great opportunity in the mortgage REIT space which I described a while back. The list of primary dealers, which are authorized to buy directly from the US government and distribute them to investors is listed below.

Source: Federal Reserve

• The Fed, in conjunction with the Treasury, will set up Special Purpose Vehicles, SPV’s, or new stand alone companies, that will lend to buy or purchase assets directly. These assets will include corporate bonds, syndicated loans, short term paper, municipal paper, ETF’s that support these assets and as of last Thursday, some junk bonds.

The last part is important because the devil is in the details and the rally in junk bond ETF’s that we witnessed last week was based on the assumption that the Fed would be able to purchase the ETF as well as the bonds that underlying the fund. Some of this is true and some is not.

Source: Yahoo Finance

A Brief Description

When I initially started digging into the details, I noticed that much of the initial press about this rally was from alarmist market commentators that bemoaned the Fed supporting another almost failing market segment, potentially enriching those that had been irresponsible, similar to the last crisis.

When you look into the details of the program and where we are in the junk credit cycle, we may find that this rally may prove to be very short lived and may leave many issuers out in the cold.

The Fed is only allowed by its charter to purchase government securities, meaning Treasuries and those agency securities I mentioned above. Everything else it would essentially have to lend to a bank or some other entity to then buy the assets. The SPV’s are being created to get around this. The Treasury will provide $75 billion of taxpayer money to provide equity to the SPV. Then the Fed will lend to that new SPV and the SPV can then use that money to either lend to other funds or banks who want to buy these assets or it can purchase them directly.

There are two main SPV’s that will be concerned with the purchase of bonds and loans. One, the Primary Market Corporate Credit Facility (PMCCF) will be for purchasing securities on the primary market and have capital of $50 billion. The other, the Secondary Market Corporate Credit Facility (SMCCF) will have $25 billion in capital.

The leverage of the SPV is limited to 10 to 1 for corporate bonds and loans that are investment grade and will be limited to 7 to 1 leverage for anything below investment grade. This means the maximum size of both SPV’s combined will be $750 billion, $500 billion for the primary market SPV and $250 billion for the secondary market SPV.

The Fed will not be the only buyer and it will have limited duration. For example, for investment grade bonds, the maturity must be in 4 years or less and they are limited to 25% of any single bond issuance or loan syndication. Other market participants must make up the other 75%. This is to ensure that the Fed is acting similar to a market participant and not just picking winners and losers, which it claims that it wants to stay away from.

Fallen Angels

When it comes to junk bonds, the next important restriction is that the purchase of any junk securities will be limited to those that were rated investment grade, ‘BBB-‘ by S&P or Fitch, ‘Baa3’ by Moody’s, as of March 22, 2020. These are the so-called “fallen angels” or investment grade securities that have subsequently lost their investment grade status. 2 out of these 3 major ratings agencies must have given the company an investment grade rating before this date. In addition, even if they were downgraded, they still must be rated ‘BB-‘ or ‘Ba3’ or higher to be considered for purchase. Why March 22 of all the dates? Well because Ford Motor Company was investment grade as of that date and was downgraded by the ratings agencies on March 24. The Fed never said explicitly that this is why they picked that date but it is widely believed that it was to be able to support Ford, potentially at the behest big those in the White House.

In addition to the junk bonds themselves, it was also announced that ETF’s that support these market segments would also be in scope for purchase. ETF’s that focus on this sector like JNK and HYG rallied as much as 7% last Thursday but this bounce may be fleeting. None of the securities that constituted those ETF’s is eligible for purchase under the program since the index that they track, the ICE U.S. BofA High Yield Index, missed its monthly rebalancing for the first time ever due to historic volatility. That means that the recently downgraded bonds that can be purchased by the Fed had not been added to the index.

As mentioned, Ford Motor Company will be one of those that made the cut off date but names like Kraft Heinz and Occidental Petroleum did not. In addition, according to the plan details, the amount that can be purchased from a single issuer will be capped at 130% of the maximum bonds and loans outstanding between March 22, 2019 and March 22, 2020. Hefty fees will need to be paid for Fed participation, 100 bps on top of what other lenders receive for both bonds and loans.

As you can see below, with the makeup of the current JNK ETF, this bond buying would still leave out about half the portfolio even if they didn’t have the cutoff date due to the fact that half is rated below ‘BB-‘.

Source: State Street

When the high yield corporate bond market itself is about $1.3 trillion, $250 billion may be enough to prop up prices of the more liquid securities, but the wild card remains the ETF’s. The Fed gave little concrete guidance as to how or under what conditions the high yield ETF’s would be purchased. Their release stated:

The Facility also may purchase U.S.-listed ETFs whose investment objective is to provide broad exposure to the market for U.S. corporate bonds. The preponderance of ETF holdings will be of ETFs whose primary investment objective is exposure to U.S. investment-grade corporate bonds, and the remainder will be in ETFs whose primary investment objective is exposure to U.S. high-yield corporate bonds.

What this remainder is and how much there will be is not clear but the speculators who helped rally these ETF’s by 7% last week clearly think there will be enough to tilt an ETF with a market cap of $9.5 billion in the case of JNK.

Where the Little Guy Loses

What is frustrating from an investor’s point of view is that the lack of guidance on support really leaves these levels up to speculation. If the Fed was buying most of the underlying bonds we could get a sense of a price floor. Leaving out most of the underlying assets but purchasing the ETF is a very indirect way of buying the bonds themselves and gives us no sense of where they will stop. Even a purchase of a few hundred million of an ETF would be more than enough to dramatically swing prices given that the daily market volume is currently about a billion dollars.

This provides a bit of a new unknown for those looking to invest in US junk bonds. Junk bonds tend to act like equity when distressed, falling and rising dramatically in value, which offers the opportunity to make a lot of money for those willing to bear the risks. Yields often spike just before defaults do. Default rates in the junk market can be as high as 20% but as the economy stabilizes and things start to return to some sense of normal, spreads come down and those that invested at peak yields stand to profit handsomely. Just take a look at how yields changed during the last 2 downturns for the index below.

When yields jump, these are great opportunities for smaller investors to jump into the market and secure yields in the teens or even better as I was able to do during the last crisis. The way this crisis is playing out though, it seems that the only people who will be able to purchase illiquid assets at a deep discount will once again be the rich and well connected.

The Fed’s actions now may disrupt the yield/default correlation that is part of the normal credit cycle. As of yesterday, yields had not even reached peak levels seen in the dot com bust, let alone the levels seen during the Great Recession, where the Fed did not intervene in the junk market. Could “do whatever it takes” really mean “a put on everything?”.

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