Secondary Market Corporate Credit Facility: Analysis and Consequences

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Earlier this week I wrote about the Primary Market Corporate Credit Facility (PMCCF). Today, I will follow up with an analysis of its counterpart – the Secondary Market Corporate Credit Facility (SMCCF). The SMCCF and PMCCF both aim to support the flow of credit to large firms. The key difference between the two is that the SMCCF supports liquidity in existing markets, while the PMCCF is designed to support new bond and loan issuances. Similar to the PMCCF, the SMCCF will take the form of an SPV that will purchase existing individual corporate bonds as well as corporate bond portfolios in the secondary market.

The facility works like this – the Federal Reserve Bank of New York (FRBNY) will lend to the aforementioned SPV on a recourse basis and the FRBNY’s loans will be fully secured by the entirety of the assets held by the SPV. Finally, the Treasury will seed the SPV with $10 billion using the Exchange Stabilization Fund, the FRBNY will in turn leverage the $10 billion investment to purchase existing bonds and bond portfolios in the secondary markets. I will highlight what I consider to be the most important aspects of the SMCCF and discuss potential consequences of the facility below.

Key Aspects

The SMCCF will mirror the guidelines of the PMCCF when it comes to the purchase of individual corporate bonds – they must be BBB or better by a major NRSRO. Specific to SMCCF is that the bond being purchased must have a remaining maturity of five years or less to be eligible. Moreover, the SMCCF will be purchasing eligible bonds at fair market value in the secondary market. The rationale here is that the FRBNY will, through the SPV, mitigate existing volatility and provide stability in the credit markets by insuring there remains a buyer for existing corporate debt.

In addition to individual corporate bonds, the SMCCF will purchase corporate bond portfolios which (for now) are only limited to exchange traded funds (ETFs). This is, in my opinion, the most profound point of departure we’ve seen the Fed take over the course of the pandemic and it is certainly unprecedented. The investment objective here is to provide broad exposure to the market for U.S. investment-grade corporate bonds. The specifics are presented below:

  • The SMCCF can purchase up to 10% of an issuer’s maximum bonds outstanding at any time between March 22, 2019 and March 22, 2020.
  • The SMCCF can purchase up to 20% of the assets of any one ETF as of March 22, 2020.
  • Finally, and this is a key provision, the SMCCF will not purchase shares of ETFs at a price that materially exceeds the estimated net asset value of the ETF’s underlying portfolio. This is supposed to mitigate substantial losses, should the portfolios buckle.

Both eligible purchases under the SMCCF will have tangible impacts in the secondary markets, but my primary focus for this piece will be to drill down on the former. As stated previously, the Fed making direct investments in the corporate bond portfolios is certainly a new frontier that is sure to result in a slew of consequences, both intended and unintended.

Consequences of the SMCCF

In my opinion, the most interesting consequence has been the market’s reaction to the announcement of the new facility. Companies have started issuing massive sums of corporate debt in anticipation of the SMCCF and the HYG Fund (a corporate bond ETF) experienced its most significant single day spike in value since 2009 late last week (depicted below).

Source – ETF.com segment: Fixed Income: U.S. – Corporate, Broad-based High Yield

Again, keep in mind that this spike was wholly attributed to the Fed’s announcement. The facility has yet to be implemented and therefore no bonds or shares of bond ETFs have been acquired by the Fed through the SMCCF. In my post about the PMCCF, I expressed concern that it was effectively a bailout for imprudent firms, that it sent the message that bad behavior is acceptable. The same is true of the SMCCF, as it will provide liquidity for existing corporate bonds that would otherwise collapse. However, the speculation that it will drive in bond portfolios such as the HYG Fund is far more concerning.

Facilitating artificial growth in the corporate bond markets is dangerous because these credit facilities are effectively propping up what can be objectively considered poor investments in overleveraged firms. In doing so, they are overriding a fundamental truth – firms that egregiously mismanage money are ultimately supposed to fail. This is no longer the case, so long as a firm is large enough to issue corporate debt they will be empowered to do so. This will maintain a status quo that routinely punishes other firms and investors for making prudent financial decisions.

Conclusion

Finally, I think it is important to mention that all of this is occurring in the midst of record high unemployment filings. Each week the numbered of unemployed expands, demonstrating profound strife in the real economy. However, this inconvenient truth appears to have no bearing on the stock market as stocks once again begin to rise in the midst of these new Fed credit facilities. I mentioned above that the HYG Fund experienced it’s largest single one day valuation spike since 2009 last week – this occurred after unemployment filings were recorded in excess of 6 million. The most recent filings, adding an additional 5.2 million to initial jobless claims, are presented below.

Source – YCharts: US Initial Jobless Claims

Unfortunately, these figures once again coincide with an uptick in equity futures. Below is a graph chronicling activity within the NASDAQ Composite index over the course of today, signaling an ever-expanding chasm between Wall Street and Main Street.

Source – Yahoo Finance: NASDAQ GIDS Real Time Price

As always, thank you for taking the time to read my thoughts. If you found this information valuable, please be sure to like, subscribe and share with others. Additionally, please feel free to weigh in on these topics, I’d love to see what others are thinking!

Primary Market Corporate Credit Facility: How it Works and Where it Falls Short

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As promised, this post will expand more on the Primary Market Corporate Credit Facility (PMCCF) and address potential shortcomings. In my overview post, I outlined the mechanics of the PMCF, but didn’t provide any color on key points. In this post I will isolate what I consider the most important aspects of this facility to explain how it will work in practice. Once we have an understanding of the “fine print” we can move into a discussion about who will reap the most benefits from its implementation and address what I consider to be legitimate shortfalls with this facility.

The Fine Print

The term sheet provided for the PMCCF is relatively straight forward regarding eligibility, loan maximums, and fees. However, it takes some digging to understand an important relationship between the CARES Act and this facility. The CARES Act prohibits the payment of dividends and share buybacks, while also placing restrictions on executive level compensation until 12 months after a loan has been repaid. These are arguably the most lauded provisions of the Act as they are intended to reign in the behavior of large firms to ensure they allocate relief funding in a way that is beneficial to the employees.

Unfortunately, this provision does not apply to the PMCCF as the SPV established by the Fed to orchestrate this facility will only be purchasing bonds and syndicated, which are not direct loans pursuant to the CARES Act. The direct implication of this is that eligible issuers will be allowed to issue additional debt to a captive audience, without any prohibitions on how proceeds will be spent. Therefore, the PMCCF is more or less incentivizing the behavior that lead to a myriad of firms facing liquidity and solvency issues in the wake of the pandemic.

Now that the CARES Act loophole has been addressed, it’s important to understand how the debt limits associated with this facility are calculated. The PMCCF limits the amount of total outstanding bonds or loans for an eligible issuer participating in the facility to 130 percent of the eligible issuer’s maximum outstanding bonds and loans on any day between March 22, 2019 and March 22, 2020. For example, let’s say company A’s maximum outstanding bond and loan obligations for the period described is $2 billion. Under the PMCCF, Company A is allowed to issue an additional $600 million of bonds or loans directly to the PMCCF SPV.

Finally, let’s expand more on the notion of eligibility. Eligible issuers must have an investment-grade of at least BBB as of March 22, 2020 by a major NRSRO, which is essentially the lowest rating a bond can have while still being considered “adequate.” A BBB rating indicates medium quality, which is generous considering anything below a BBB rating is categorized as “junk” due to their highly speculative and risky nature. So, what’s the problem? The Fed has drawn the line at BBB, effectively mitigating the risk of highly speculative purchases, right? Wrong. There is an important caveat to this eligibility requirement – if the issuer was rated at least BBB as of March 22, 2020, but was subsequently downgraded, it must be rated at least BB at the time the PMCCF SPV makes a purchase. This effectively opens the floodgates to a slew of eligible junk rated bonds that will be picked up by the Fed, no questions asked.

Conclusion

The direct lending program under the PMCCF is truly an unprecedented effort by the federal government and Federal Reserve to provide liquidity directly to investment-grade corporate borrowers. In the past, the Fed would coordinate with banks to facilitate access to capital. Given the present circumstances, there are concerns that banks will be limited in their ability to provide credit to such borrowers due to existing leverage and regulatory capital requirements. Having cut the middle man out of the equation, the Fed’s new program will likely be an effective tool for investment-grade borrowers in need of refinancing or other immediate funding needs.

Ultimately, however, a strong case can be made that the PMCCF is essentially a bailout for reckless companies. Given the fact that the CARES Act prohibitions will not apply to participants in this facility, there is really no incentive to improve the behavior which placed many of the investment-grade borrowers in this position to begin with. As a result, the Fed has sent the following message – “there are no consequences for bad behavior, in fact it gets rewarded.”

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Federal Reserve Credit Facilities: An Overview

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Two weeks ago the Federal Reserve announced a set of measures that largely mirrored the response to the 2008 financial crisis. Though nuanced in some respects, the credit facilities introduced by the Fed were generally in alignment with previous practices – albeit more aggressive than in crises past. Today all of that changed. The Fed announced an additional $2.3 trillion in loans and purchases in an attempt to stabilize a volatile and languishing economy. What makes today’s measures truly unprecedented, however, is that this is the first time in their 107 year history that the Fed agreed to purchase investment grade corporate bonds – effectively nationalizing the bond market.

With the blessing of the Treasury, the Fed has officially exhausted every conceivable measure at their disposal by extending credit to the most vulnerable verticals of the bond market – junk bonds, municipal bonds, and collateralized loan obligations (CLOs) are officially fair game. At this point, the only thing missing from the Fed’s “toolkit” is the extension of credit to purchase equities outright (but never say never). Though my opinion is clearly starting to bleed through, I will save my thoughts on the Fed’s response to the pandemic for another day. The objective of this post is to provide an overview of each credit facility that has been introduced by the Fed as of today. Considering the breadth of the existing measures, I consider it unlikely that the Fed will follow up with another announcement. For the time being, what’s presented below is an exhaustive summary of the Fed credit facilities. Highlights were taken directly from the Fed’s website.

Main Street Lending Program

  • The Fed will purchase 95% of the loan and the lender will retain 5% on its books – this is a full recourse loan with a tenor of 4 years.
  • Eligible Borrowers: businesses with up to 10,000 employees or up to $2.5 billion in 2019 annual revenues. Each eligible borrower must be a business that is created or organized in the United States with significant operations in and a majority of its employees based in the United States.
  • Loan Specifics:
    • 4 year maturity;
    • Amortization of principal and interest deferred for one year;
    • Adjustable rate of Secured Overnight Financing Rate (SOFR) +250-400 basis points;
    • Minimum loan size of $1 million;
    • Maximum loan size that is the lesser of (i) $150 million, (ii) 30% of the Eligible Borrower’s existing outstanding and committed but undrawn bank debt, or (iii) an amount that, when added to the Eligible Borrower’s existing outstanding and committed but undrawn debt, does not exceed six times the Eligible Borrower’s 2019 earnings before interest, taxes, depreciation, and amortization (“EBITDA”); and
    • Prepayment permitted without penalty.
  • There are a number of attestations that the Borrower must make to receive loan funds, but the crux of them focus on not utilizing funds to repay other loan balances. The Borrower must also make “reasonable” efforts to maintain its payroll/employees and agree to limits on compensation and stock buybacks.
  • Total Allocation: $600 billion and it will be seeded by $75 billion from the Treasury.
  • The program has not been finalized and the Fed will be receiving comments until April 16th. Details to come.

Municipal Liquidity Facility

  • The Fed will establish a Special Purpose Vehicle (SPV) to purchase municipal notes directly from eligible issuers.
  • Eligible Issuers:
    • U.S. states and the District of Columbia
    • U.S. cities with population over 1 million
    • U.S. counties with population over 2 million
  • Eligible Collateral:
    • Tax Anticipation Notes (TANs)
    • Tax and Revenue Anticipation Notes (TRANs)
    • Bond Anticipation Notes (BANs)
    • *All notes must mature in less than 2 years
  • Maximum Amount: the SPV can purchase is capped at 20% of the issuer’s fiscal year 2017 general revenue and utility revenue.
  • Pricing: will be based on the issuer’s bond rating (details forthcoming) and an origination fee of 10 basis points must be paid to participate in the facility.
  • Total Allocation: The SPV can purchase up to $500 billion in municipal notes and will be seeded with $35 billion from the Treasury. As it stands, the facility will sunset on September 30th, 2020.

Paycheck Protection Program Lending Facility

  • This facility exists to facilitate additional lending to small businesses under the PPP provision of the CARES Act. The Fed will take the PPP note as collateral, with no recourse to the borrower.
  • Eligible Borrowers: Depository institutions that are approved to originate PPP loans. The program will likely expand to include non-depository institutions participating in the program.
  • Rate and Fees: Extension of credit under the facility will be made at a rate of 35 basis points; there are no fees associated with this facility.
  • Collateral Valuation: PPP loans pledged as collateral to secure extensions of credit under the facility will be valued at the principal amount of the PPP loan.
  • Maturity Date: Credit extended by the Fed will have a maturity date equal to the PPP loan, but the maturity rate will be accelerated if the underlying asset goes into default and the eligible borrower sells the underlying asset to the SBA to realize the 100% SBA guarantee.
  • Regulatory Capital Requirements: The PPP loan will be assigned a risk weighting of 0% and PPP loans financed by this facility can be neutralized by banking organizations for leverage capital ratio requirements.

Term Asset-Backed Securities Loan Facility

  • The Term Asset-Backed Securities Loan Facility (TALF) is intended to help meet the credit needs of consumers and businesses by facilitating the issuance of asset-backed securities (ABS).
  • Under TALF, the Federal Reserve Bank of New York will commit to lend to an SPV on a recourse basis.
  • Eligible Borrowers: All U.S. companies that own eligible collateral and maintain an account relationship with a primary dealer are eligible to borrow under TALF.
  • Eligible Collateral: Must be an ABS where the underlying credit exposures are one of the following:
    • Auto loans and leases;
    • Student loans;
    • Credit card receivables (both consumer and corporate);
    • Equipment loans and leases;
    • Floorplan loans;
    • Insurance premium finance loans;
    • Certain small business loans that are guaranteed by the SBA;
    • Leveraged loans; or
    • Commercial Mortgages
    • *Eligible collateral will not include ABS that bear interest payments that step up or down to predetermined levels on specific dates. In addition, the underlying credit exposures of eligible collateral must not include exposures that are themselves cash ABS or synthetic ABS.
  • Term: Three years; non-recourse to borrower.
  • Pricing:
    • For CLOs, the interest rate will be 150 basis points over the SOFR;
    • For SBA Pool Certificates (7(a) Loans), the interest rate will be the top of the federal funds target range plus 75 basis points
    • For SBA Development Company Participation Certificates (504 Loans) the interest rate will be 75 basis points over the 3-year fed funds overnight index swap (OIS) rate.
    • For all other eligible ABS with underlying credit exposures that do not have a government guarantee, the interest rate will be 125 basis points over the 2-year OIS rate for securities with a weighted average life less than two years, or 125 basis points over the 3-year OIS rate for securities with a weighted average life of two years or greater. The pricing for other eligible ABS will be set forth in the detailed terms and conditions.
  • Fees: The SPV will assess an administrative fee equal to 10 basis points of the loan amount on the settlement date for collateral.
  • Total Allocation: The TALF SPV will initially make $100 billion of loans available and will be seeded with $10 billion from the Treasury.

Primary Market Corporate Credit Facility

  • This facility will serve as a funding backstop for corporate debt issued by eligible users. Under the facility, the Federal Reserve Bank of New York will commit to lend to an SPV on a recourse basis.
  • The SPV will purchase:
    • Qualifying bonds as the sole investor in a bond issuance;
    • Purchase portions of syndicated loans or bonds at issuance.
  • Collateral: The Reserve Bank will be secured by all assets of the SPV.
  • Eligible Assets:
    • Eligible corporate bonds as sole investor. Eligible corporate bonds must: be issued by an eligible issuer and have a maturity of 4 years or less.
    • Eligible syndicated loans and bonds purchased at issuance. Eligible syndicated loans and bonds must: be issued by an eligible issuer and have a maturity of 4 years or less. The facility may purchase no more than 25 percent of any loan syndication or bond issuance.
  • Eligible Issuers:
    • Must be a business that is created or organized in the U.S. or under the laws of the U.S.
    • Must be rated at least BBB-/Baa3 as of March 22, 2020 by a major nationally recognized statistical rating organization (NRSRO).
      • Issuers that were rated at least BBB-/Baa3 as of March 22, 2020, but are subsequently downgraded, must be rated at least BB-/Ba3 at the time the Facility makes a purchase.
    • The Issuer is not an insured depository institution or depository institution holding company.
    • The Issuer must satisfy conflicts-of-interest requirements as set forth by the CARES Act.
  • Leverage: Corporate bonds & loans can be levered 10:1, other assets can be levered 7:1.
  • Pricing:
    • Eligible corporate bonds: Pricing will be issuer specific, pursuant to market conditions, plus a 100 basis point facility fee.
    • Eligible syndicated loans and bonds: The facility will receive the same pricing as other syndicate members, plus a 100 basis point fee on the facility’s share of the syndication.
  • Total Allocation: Not to exceed $750 billion, seeded by $75 billion in Treasury funding.

Secondary Market Corporate Credit Facility

  • This program is very similar to the primary market corporate credit facility. The main difference here is that this facility will be used to purchase corporate bonds as well corporate bond portfolios issued on the secondary market.
  • Key differences are eligible asset classes, eligible sellers, and pricing. All other requisites remain the same as above.
  • Eligible Assets:
    • Eligible Individual Corporate Bonds: Must purchase bonds that were issued by an eligible issuers; have a maturity of 5 years or less; were sold to the facility by an eligible seller.
    • Eligible ETFs: 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.
  • Eligible Seller: Each institution from which the facility purchases securities must be a business that is created or organized in the United States or under the laws of the United States with significant U.S. operations and a majority of U.S.-based employees. The institution also must satisfy the conflicts-of-interest requirements of section 4019 of the CARES Act.
  • Pricing: The facility will purchase eligible corporate bonds at fair market value in the secondary market. The facility will avoid purchasing shares of eligible ETFs when they trade at prices that materially exceed the estimated net asset value of the underlying portfolio.

Conclusion

This was a longer post than usual and certainly dense, but I hope you were able to find this information useful. These are the tools that will be utilized to stabilize credit markets in the U.S. and (hopefully) divert a deep recession as we navigate the coronavirus pandemic. As always, if you found this informative please like, subscribe, and share with your network.