We have to hand it to The Federal Reserve; what they have managed to do with the investment-grade and high-yield bond and loan market has been remarkable. Back in March, they announced a Secondary Market Corporate Credit Facility (SMCCF) to provide liquidity to frozen markets. They would use this facility to buy investment-grade corporate bonds, high-yield corporate bonds that were investment-grade prior to March 20, 2020, and investment-grade ETFs. The U.S. Treasury provided $25 billion in capital, which meant that the Fed could buy about $250 billion.
From that announcement, investment-grade corporate bonds, (using the MARKIT CDX IG 5-year Index) have tightened 85 basis points, or 56% from their widest. High-yield corporate bonds (using the MARKIT CDX HY 5-year Index) have tightened 443 basis points, or 50% from their widest, and high-yield leveraged loans (using the S&P/LTSA Leveraged Loan Price Index) has increased in price 14 points and is now back to the “Mendoza Line” for that asset class, at $90.
For those who do not follow baseball, Mario Mendoza was a slick-fielding shortstop who played in the Major Leagues in the 1970s. Mario was such a poor hitter, however, that he established the line in batting average futility of .200 and hence, “The Mendoza Line.” Additionally, this melt-up in corporate debt occurred while nearly $1 trillion of new corporate debt was issued!
The most remarkable thing about what has happened in the corporate debt market; a phenomenon sparked by the Fed’s announcement of the SMCCF is, other than buying a relatively small number of ETFs, the Fed has purchased ZERO corporate bonds. The market did all their work for them. This reminds us of the all-time classic novel, “The Adventure of Tom Sawyer” by Mark Twain. Remember when Aunt Polly laid down the law to Tom by making him whitewash a fence?
"Tom appeared on the sidewalk with a bucket of whitewash and a long-handled brush. He surveyed the fence, and all gladness left him and a deep melancholy settled down upon his spirit. Thirty yards of board fence nine feet high. Life to him seemed hollow, and existence but a burden."
Tom then comes up with a brilliant idea. He tricks the other neighborhood boys into thinking that whitewashing a fence is perhaps the greatest thing ever. Within minutes, Tom is sitting under a shade tree while all his friends are happily doing his work. In fact, they fight over who gets to do the most.
The Fed, with the announcement of SMCCF, along with their recent history of doing what they say they are going to do, was all investors needed. For the last two months, investors have been battling with each other to get those bonds the Fed said they were going to buy. In actuality, the Fed did nothing. With regard to the frenzied buying, we also have the great lesson Tom Sawyer learned from his trickery:
"He had discovered a great law of human action, without knowing it—namely, that in order to make a man or a boy covet a thing, it is only necessary to make the thing difficult to obtain."
The problem, as we see it, is certainly there were solid corporate credits that became extremely cheap in March and deserved to be fought over. However, many credits, especially in the non-investment grade department, were in bad shape before the COVID-19 effects took place. Many have referred to such companies as “zombie companies,” alive only as long as they can roll existing debt and borrow more. These companies probably deserved the valuations they were getting in March; if they were getting any at all. Now, they can issue new debt into this investor feeding frenzy. In fact, Chairman Powell said this week that the borrowing spree is a “really good thing,” and the bond sales help avoid turning “liquidity problems into solvency problems.”
The Fed has been hesitant to tie its post-2008 monetary policy to the dramatic price increase of financial assets and the associated increase in risk-taking of many market participants. Taking more risk and receiving less reward is sort of an “Alice in Wonderland” type of experience.
We wonder if the Fed truly understands the problem with creating a feeding frenzy. At the outset of the feeding frenzy, the Fed is perceived to be underwriting the risk-taking. The instruments that really only have a liquidity problem -normally liquid, creditworthy, and just stuck because the market seized- go very quickly. However, the feeding frenzy does not stop. Before long, bonds that indeed have “solvency problems” start trading a lot better than they should, and they begin pricing in a remarkable turnaround in the economy and the fortunes of these troubled companies.
Chairman Powell also stated this week, “We crossed a lot of red lines that had not been crossed before.” He added that he was comfortable with what the Fed had done given, “This is that situation in which you do that, and you figure it out afterward.”
What may happen “afterward” is for every investor who sees the ruse, there are 19 standing there with whitewash all over their clothes and bad bonds stuck in their portfolios, clueless that they were fooled.
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