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.
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).
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.
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.
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.
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!