On 6 March 2020, the president of the Federal Reserve Bank of Boston, Eric Rosengren, urged that Congress should grant the Federal Reserve the authority to buy corporate bonds as part of its open market operations.1 On 23 March 2020, the Federal Reserve announced that it would buy investment grade corporate bonds in order to limit the deterioration of corporate financing conditions in the midst of the Covid-19 pandemic.
In the eventful intervening 17 days, investors had ‘dashed’ for cash and mounted a run on money market mutual funds which invest in commercial paper (corporate IOUs).2 In response, the Federal Reserve invoked its emergency lending powers, as it had in 2008, in order to buy commercial paper. It also reprised its underwriting of reissuance of maturing paper, setting a maximum spread over interbank rates. The Federal Reserve’s quick response stabilised the commercial paper market (where firms finance inventory and payroll).3
After the Federal Reserve backstopped money market funds, however, the run continued on corporate bond funds.4 Net redemptions from bond mutual funds exceeded $5 billion a day in mid-March (Figure 1). To meet these redemptions, fund managers dumped corporate bonds.
Figure 1 Flows to US corporate bond mutual funds (in billions of dollars, week ending the indicated day)
Source: McCauley (2020) citing Investment Company Institute, Collins (2020).
Ominously, many a bond exchange traded fund came to trade at a steep discount with respect to its net asset value (the total value of its individual bond holdings). In a strained market, savvy investors trust the exchange traded fund price more than often-imputed individual bond prices. Investors thus saw exchange traded fund discounts as actionable predictions of bond price declines. Faced with such vicious dynamics in their main funding market, many firms tapped banks using backup credit lines in another dash for cash.5
Following some public discussion of the Federal Reserve’s purchase of corporate bonds,6 the announcement on 23 March 2020 did not come completely as a surprise. Still, prices of bond exchange traded funds jumped. The largest asset in this class, ‘LQD’, gained 6.6% at the opening of trading, and 7.4% on the day.7 The eight other investment grade exchange traded funds that the Federal Reserve bought also enjoyed tidy one-day gains (Table 1).8
Table 1 Investment grade corporate bond ETFs held by Federal Reserve, 19 May and 19 June 2020
Sources: Federal Reserve; New our Stock Exchange ARCA; Fidelity as of 25 June.
The market response to this Federal Reserve announcement ‘bulks large’ by the standards of the response to ECB President Draghi’s statement, “whatever it takes”. The long-duration LQD yield declined by 75 basis points, while Table 1’s shorter duration funds declined by around 200 basis points (Haddad et al. 2020) as the Federal Reserve focused on intermediate-term bonds. It took the ECB announcements in July, August, and September 2012 to squeeze the two-year spreads of Italy and Spain to such an extent (Altavilla et al. 2014). The ECB ruled out the euro’s breakup, the Federal Reserve, a protracted run on the corporate bond market.9
A remarkable feature of the price gain on 23 March 2020 is that it took place in exchange traded fund discounts/premia, rather than in net asset values. The ‘LQD’ price swung 5.7% from a discount of 2.8% on 20 March 2020, to a premium of 2.9% on 23 March. In comparison, the net asset value gained only 1.4% (Figure 2).10 For the other eight funds that the Federal Reserve would buy, basically all the action was in the discount/premium. In effect, the Federal Reserve switched the market ‘billboard’ from ‘SELL’ to ‘BUY’.
Figure 2 Fed corporate bond announcement 23 March raises ETF premia more than NAVs
Note: See Table 1 for fund names.
Only in the days after 23 March 2020 did spreads on investment grade corporate bonds narrow significantly. Faria-e-Castro et al. (2020) provide a careful transaction analysis, finding that credit spreads fell simultaneously for ‘junk’ bonds. Similarly, Kargar et al. (2020) show that dealing spreads narrowed for high- and low-quality bonds after 23 March 2020. Even dollar bonds issued by non-US borrowers rallied.11 Through portfolio substitution, the Federal Reserve’s ‘buy’ signal reverberated widely in the $1 trillion domestic junk bond market, as well as in the larger market for dollar bonds from non-US issuers.12
In a surprising move, on 09 April 2020 the Federal Reserve announced that it would buy junk bonds in exchange traded funds.13 Despite the earlier recovery of junk bond prices and trading spreads, the seven junk bond exchange traded funds that the Federal Reserve ultimately purchased gained 5-7% on announcement (Table 2). Investment grade exchange traded funds also rose again by substantial amounts (Table 1). Over half (i.e. 12.1% of the 17.4%) of the gain in the ‘LQD’ asset price between its trough on 20 May 2020 and the day before the Federal Reserve started buying stocks occurred right after the two Federal Reserve announcements.
Table 2 Speculative grade corporate bond ETFs held by Federal Reserve, 19 May and 19 June 2020
Sources: Federal Reserve; New our Stock Exchange ARCA; Fidelity as of 25 June.
Although the junk bond primary market re-opened in late March, the announcement on 09 April 2020 kicked issuance higher (Figure 3).14 With declining revenues, downgrades, and thin cash buffers, junk bond issuance has not set records as investment grade issuance has.
Figure 3 US junk bond issuance by week, 2020 (in millions of dollars in the week ending on the date indicated)
In an anti-climax, the Federal Reserve actually started to buy corporate exchange traded funds on 12 May 2020, seven weeks after the announcement. In mid-June, it switched from buying exchanged trade funds to buying individual bonds, using a ‘home-rolled’ index. The start of actual buying had little effect on pricing (Tables 1 and 2).15
Purchases declined unevenly from $300 million per day to zero in July (Figure 4).16 By then, the market was in fine fettle. First-half 2020 issuance of corporate bonds had easily broken all records.17 Firms had gone from ‘paying up’ for precautionary funding to taking cheap funds opportunistically.
Figure 4 The Fed’s corporate ETF and bond purchases (daily amount, week ended the date shown in millions of dollars)
Source: Federal Reserve, “Factors affecting reserve balances”, H4.1 release; author’s estimates.
Note: Purchases proxied by change in holdings. Effect of the addition of 85% of the US Treasury equity to the Corporate Credit Facilities LLC is removed.
Several less-than-ideal features of policy implementation arose from Federal Reserve inexperience in corporate bond operations and its work-around in terms of using its emergency lending powers. First, exchange traded fund purchases and bond purchases followed the 23 March 2020 announcement by seven and 11 weeks, for good reasons. Second, the Federal Reserve tapped outsourced expertise, a Blackrock affiliate, in order to execute the strategy. Third, and most troublingly, the Federal Reserve bought the worst-rated junk bond based on market capitalisation. Many arose from private equity deals that loaded firms with as much debt as possible, despite Federal Reserve warnings. Buying individual junk bonds would have allowed the Federal Reserve to not buy the bonds of firms that it warned banks not to lend to. Regular operations in corporate bonds would have made this possible.
Congress should authorise the Federal Reserve to buy and to sell corporate bonds in its regular open market operations alongside US Treasury securities. The Federal Reserve could then be up to speed to do operations without delay, without outsourcing, and without friction between its bank supervisory and market stabiliser roles. Federal Reserve operations need to catch up with market developments: large firms rely on capital markets for funding, not banks. It is better to make this transition before the next crisis.
Acharya, V and S Steffen (2020), “The risk of being a fallen angel and the corporate dash for cash in the midst of COVID”, Covid Economics 10.
Altavilla, C, D Giannone and M Lenza (2014), “The financial and macroeconomic effects of OMT announcements”, ECB Working Papers Series 1707.
Aramonte, S and F Avalos (2020), “The recent distress in corporate bond markets: cues from ETFs”, BIS Bulletin 6, 14 April.
Baba, N, R McCauley and S Ramaswamy (2010), “US dollar money market funds and non-US banks”, BIS Quarterly Review, March 2009: 65-81.
Banerjee, R, A Iles, E Kharroubi and JM Serena (2020), “Covid-19 and corporate sector liquidity”, BIS Bulletin 10, 28 April.
Bernanke, B and J Yellen (2020), “The Federal Reserve must reduce long-term damage from coronavirus”, Financial Times, 18 March.
Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency (2013), “Interagency guidance on leveraged lending”, 21 March.
Board of Governors of the Federal Reserve System (2020), Monetary policy report, June.
Boyarchenko, N, A Kovner and O Shachar (2020), “It’s what you say and what you buy: a holistic evaluation of the Corporate Credit Facilities”, Federal Reserve Bank of New York Staff Reports 935, July.
Cheng, J, D Wessel, and J Younger (2020), “How did COVID-19 disrupt the market for U.S. Treasury debt?”, Brookings Institution, Hutchins Center Explains, 01 May.
Chursin, J, J Rogers and T Marshella (2018), “LBO credit quality is weak, bodes ill for next downturn”, Moody’s Investor Service, Leveraged Finance – US: Tracking the largest private equity sponsors, 18 October.
Collins, S (2020), “Fund flows during Covid-19”, Investment Company Institute presentation, 27 May.
Committee on the Global Financial System (2019), “Unconventional monetary policy tools: a cross-country analysis”, CGFS Papers 63, 07 October.
D’Amico, S, V Kurakula and S Lee (2020), “Impacts of the Fed Corporate Credit Facilities through the lenses of ETFs and CDX”, Federal Reserve Bank of Chicago Working Paper WP 2020-14, 17 May.
Faria-e-Castro, M, J Kozlowski and M Ebsim (2020), “Corporate bond spreads and the Pandemic”, Federal Reserve Bank of St Louis, On the economy blog, 09 April.
Fleming, M (2020), “Treasury market liquidity and the Federal Reserve during the COVID-19 Pandemic”, Liberty Street Economics 27 May.
Hadad, V, A Moreira and T Muir (2020), “When selling becomes viral: disruptions in debt markets in the COVD-19 Crisis and the Fed’s response”, NBER Working Paper no 27168, May.
Kargar, M, B Lester, D Lindsay, S Liu, P-O Weill and D Zúñiga (2020), “Corporate bond liquidity during the Covid-19 crisis”, NBER Working Paper no 27355, June.
Li, L, Y Li, M Macchiavelli and X (A) Zhou (2020), “Runs on prime money funds during the COVID-19 crisis”, VoxEU.org, 14 July.
Martin, A and S McLaughlin (2020), “The Primary Dealer Credit Facility”, Liberty Street Economics, 27 May.
McCauley, R (2020), “The Fed in the corporate bond market in 2020”, Boston University Global Development Center GEGI Working Paper 041, August.
Norton, L (2020), “Expect the Fed to buy corporate bonds, says Ed Yardeni”, Barron’s, 17 March.
Rosengren, E (2020), “Observations on monetary policy and the zero lower bound”, remarks for a Panel Discussion at the 2020 Spring Meeting of the Shadow Open Market Committee: “Current monetary policy: the influence of Marvin Goodfriend”, New York, 06 March.
Schrimpf, A, H S Shin and V Sushko (2020), “Leverage and margin spirals in fixed income markets during the Covid-19 crisis”, BIS Bulletin 2, 01 April.
Singh, D (2020), “Implementing the Fed’s facilities: moving at maximum speed with maximum care”, remarks before the Money Marketeers of New York University, 17 April.
1 Rosengren’s suggestion that the US Treasury indemnify the Fed against losses from the corporate bonds is more politics than economics since the Fed hands over its profits to the US Treasury.
2 See Baba et al. 2020. Li et al. 2020 argue that the money market fund reform of temporary suspension of redemption (so-called “gates”) actually accelerated the run.
3 Collins (2020) shows that the Fed extended less credit to stabilise the commercial paper in 2020 than it had in 2008, despite in effect buying all nonbank commercial paper in 2020 versus just asset-backed commercial paper in 2008. The Fed also reprised its spring 2008 opening of the discount window to primary dealers as the US Treasury market went haywire. See Martin and McLaughlin 2020, Cheng et al. 2020, Fleming 2020, Schrimpf et al. 2020.
4 Aramonte and Avalos 2020 contend that the Fed’s backstop of money market funds led alert investors to switch into them from short duration corporate bond funds, accelerating the run.
5 See Acharya and Steffan 2020 and Banerjee et al. 2020.
6 At least one economist had prominently predicted it (Norton 2020), and two former Fed chairs had urged it in the Financial Times (Bernanke and Yellen 2020).
7 Haddad et al (2020) show that intraday movements point to the effect of the Fed’s announcement before the market opened.
8 For an analysis of a broader sample of corporate ETFs, see D’Amico et al. 2020.
9 The reflection of central bankers in the Committee on the Global Financial System (2019, p 34) on the ECB promise to buy bonds applies to the Fed’s corporate bond announcement: its “outsized effect, and the critical timing at which it occurred, point to the possible role that monetary policy ... can play in ruling out adverse self-fulfilling outcomes, at least in some circumstances”.
10 The fact that LQD and USIG show the best NAV performance points to price gains in longer maturity bonds on 23 March.
11 The largest emerging market ETF, VWO dropped by 1% on 23 March, but then gained 14.2% over the next 3 days.
12 The BIS counts dollar bonds outstanding of non-US residents (other than banks), as having grown from $2.5 trillion at end-2008 to $6.3 trillion at the end of 2019 (https://stats.bis.org/statx/srs/table/e2?m=USD&f=pdf).
13 It also extended the March 23 investment grade programmes to bonds of investment grade issuers on March 22 that had since been downgraded--“fallen angels” like Ford.
14 Yum Brands of Kentucky Fried Chicken fame re-opened the junk bond market on 30 March. “While investment-grade issuance recovered at a strong pace following the March Federal Reserve announcement on corporate credit funding facilities, high-yield issuance began to pick up only after the April announcement to expand the facilities to include support for some recent ‘fallen angels’ [...] and high-yield exchange-traded funds” (Board of Governors of the Federal Reserve 2020).
15 Boyarchenko et al. 2020 find little price effect on underlying bonds purchased through ETFs after 12 May.
16 The rise in the value of the portfolio in the most recent weeks shown in Figure 4 reflects price appreciation.
17 See Boyarchenko et al. 2020 for effects of the Fed buying of corporate bonds on the primary market.
18 Singh 2020 describes the protocols and controls that took time to put into place.
19 See Chursin et al 2018 for an analysis of the high leverage associated with private equity deals and Board of Governors et al. 2013.