This is a guest post by Robert McCauley, a non-resident senior fellow at Boston University's Global Development Policy Center and senior research associate at the Global History of Capitalism project in the Oxford Centre for Global History at the University of Oxford. In it, he argues that the Fed, in following through on its announced intention to buy junk bonds, should not buy ETFs representing the whole market. Instead, it should buy a more selective, non-indexed mutual fund or individual bonds based on clear, defensible criteria.
In a move that surprised many, the Federal Reserve announced on April 9 that it would buy junk bonds by purchasing exchange-traded funds (ETFs). This followed the announcement on March 23 that it would underwrite and buy investment grade bonds, directly and through ETFs. On April 9, the Fed also extended the March 23 programmes to bonds that had been investment grade on March 22, but had since been downgraded, so-called fallen angels like Ford.
Why is the Fed buying junk bonds?
One argument is to break perverse market dynamics. Wide spreads on outstanding bonds per se may be borne by refinancing firms deleveraging. But if losses from wider spreads lead bond-fund investors to sell their shares, the force of the funds’ fire-selling can lead to a spiral of lower prices and redemptions. Such a run on the market can close the market for new issues. A closed market can in turn lead to defaults, as well as reduced hiring and investment. Corporate defaults impose dead-weight losses on creditors, suppliers, customers and owners that are not limited to legal costs.
Since the emergence of original-issue junk bonds in the 1980s, the primary market for them has closed for a stretch only three times. It closed in 1990, around the failures of Campeau, a leveraged Canadian store chain, and junk underwriter Drexel. On that occasion, the market re-opened only after leveraged buyout (LBO) firm KKR invested more equity in RJR Nabisco, defusing a bond that was supposed to pay an impossibly high yield to trade at par. The market also closed in 2000 following the fraud-related collapse of WorldCom, an aggressive telecommunications firm. And finally, it closed again in 2007-08 during the Great Financial Crisis (GFC).
This time around, amid growing apprehension of the pandemic, investor redemptions of junk bond funds and rising secondary market yields, the primary market closed in the first week of March 2020. It remained closed for over three weeks as investors dumped junk bond funds. But the Fed’s March 23 announcement that it was going to underwrite and buy investment grade bonds led to big issuance by investment grade firms willing to pay up to demonstrate access. Against this backdrop of very large issues marketed by bankers working at home, Yum Brands, the owner of KFC and Pizza Hut brands, braved the junk market on March 30. It sold an oversubscribed issue yielding 3 per cent more than its previous offering. Indeed, in the last week of March, investors returned to net buying of junk bond funds.
Thus, the Fed’s decision to buy junk bonds came before a sustained closure of the market as seen in earlier episodes. Evidently, the Fed’s promise to underwrite and to buy investment grade bonds had already broken the run on that market. The demonstration that big deals could be done at the right price spilled over into the junk market, as did the return of investor buying of bond mutual funds. It is not a criticism to say that the Fed acted before the primary junk bond market disappeared for months.
Should the Fed buy junk bond ETFs that track broad indices?
The $18bn HYG or the $8bn JNK funds track competing dollar junk indices. Buying into them appears an attractive option, allowing the Fed seemingly not to choose what to buy. Consider three possible drawbacks from least to most serious.
First, such indices include bonds of non-US issuers—you might say Yankee junk. One of HYG’s biggest holdings for example is a highly leveraged French-headquartered telecom firm, Altice, with 1.8 per cent weight on April 23. It is easier to argue for buying Sprint with a 2.1 per cent weight, even though it is now owned by Deutsche Telekom’s T Mobile.
Other foreign firms include an Israeli-American drug company, three other European telecom companies, and a couple of European banks. Fidelity’s website features “third-party analytics” that show the US exposure of HYG at 77 per cent of the portfolio. Most of the non-US based issuers probably have US operations large enough to qualify under the equivalent of the Bank of England’s criterion for buying bonds of non-UK firms. That is, they “make a material contribution to [US] economic activity”. Perhaps the completely foreign component of HYG is not a big drawback.
A second drawback is more serious. A low quality bond index weighted by market capitalisation is a crazy idea. In principle, the shakier the bonds that other investors accept, the riskier one’s investment. In practice, as investors reached for yield in the long upswing after the GFC, the index shovelled funds down the rating spectrum away from hedge finance, to speculative finance and then to Ponzi finance. Now, as sales have shrunk and fallen angels like Ford join the index, it reallocates funds toward the top end of junk, the Ba/BB bonds. Should the Fed buy into this the sort of pro-cyclical dynamic?
The third drawback is most serious. The Fed as buyer of last resort should strive for consistency with the Fed as bank supervisor.
Since 2013, US bank regulators including the Fed have urged banks to steer clear of highly leveraged loans that burden firms with debt in excess of six times cash flow. In the event, securities and private equity (PE) firms stepped in to underwrite such loans, while collateralised loan obligations (CLOs) and junk loan mutual funds stepped in as holders of them. While the activity scooted from the banks into shadow banks, thanks to this policy bankers find themselves in a stronger position today. Less burdened with a pipeline of unsaleable loans, they are more able to absorb losses in credit cards and elsewhere. It would be awkward for the Fed to buy junk bonds of firms that resulted from deals that it wisely discouraged banks from joining.
PE firms, including LBO firms, have systematically leveraged the firms that they own above the supervisory guidance. Moody’s published a prescient study in October 2018 entitled “LBO credit quality is weak, bodes ill for next downturn”. The average leverage of firms owned by PE firms exceeded six times cash flow for 13 out of the top 16 PE firms. The overall average for speculative grade debt was 5.3 times. Three of the 13 averaged a ratio over seven of debt to cash flow.
If the Fed buys HYG, what fraction of its investment goes into bonds of highly leveraged firms owned by PE firms? It is easier to pose this question than to answer it. Over half of HYG was rated B or lower by Moody’s at end-February 2020, according to the fund’s annual report. Moody’s found that of 699 junk-rated firms owned by PE, 643 or 92% were B2-rated or below. For the 848 junk-rated firms not owned by PE, only 339 or 40 per cent were rated so low. Could as much as 20-30 per cent of HYG consist of bonds issued by firms that are owned by PE firms? Even if the share is lower because PE firms have found the leveraged loan market more accommodating, should the Fed buy such junk bonds? Groucho Marx refused to join any club that would let him in. Should the Fed join a club that it wouldn’t let banks in?
How should the Fed buy junk bonds?
There are two alternatives. One, the Fed could instead buy a fund like Vanguard’s big open-ended fund that overweights Ba/BB-rated credits. With its low fees, the memorably named VWEAX exceeds HYG in size at $22bn. Bonds rated B2 or below amounted to only 31.4 per cent of the fund at end-March 2020. In buying this fund, the Fed would put much less money into the bonds of highly leveraged PE-owned firms. PE firms are sitting on plenty of “dry powder” to deal with their own progeny, as KKR dealt with financial distress at RJR Nabisco.
Are there technical objections to the Fed buying a non-exchange-traded junk bond fund in an end-day transaction? Whatever they may be, they lose force when one considers the gap between even daily trading of such a fund and trading by appointment in many of the underlying bonds. Should the Fed buy into the even more profound illusion of instant liquidity of junk bond ETFs?
The second alternative is that the New York Fed’s traders could join their counterparts in Europe in rolling up their sleeves to buy individual bonds that meet defensible criteria. In the process, they might just learn how to improve market liquidity. With this approach, one could even imagine the operation morphing from last-resort buying to last-resort dealing.
In short, if the Fed is to buy junk bonds, it should either buy into a thoughtfully constructed fund or buy the underlying bonds itself.