Have Central Bank Interventions Repriced Corporate Credit? Part 3

The Ongoing Influence of Fed Intervention

The markets responded immediately when the US Federal Reserve announced it would intervene in corporate credit markets to bolster the economy amid the pandemic outbreak. Swift central bank action combined with fiscal stimulus drove an incredible economic rebound and a massive rally in risk assets that sent credit spreads back to pre-COVID-19 levels by year-end 2020.

Still, the low spreads in late 2020 and throughout much of 2021 were not unprecedented. Similar spreads preceded both the pandemic and the global financial crisis (GFC) without COVID-19-levels of monetary and fiscal support.

Spread volatility tells a similar story. As the figure below demonstrates, spread volatility in the United States decreased significantly from its peak during the March 2020 selloff. But the low volatility post-pandemic was well within historical norms and did not signal a regime change.

Post-Pandemic Spreads Are Not Unprecedented

Unlike their European counterparts, US investment-grade month-end spreads widened to within 20 basis points (bps) of the fair value model’s estimates in March 2020. By late March 2020, the Fed had announced its corporate bond purchases and the market had begun to recoup its losses. To be sure, any model that anticipates something as complicated as compensation for credit risk should be treated with caution. Yet even as the European Central Bank (ECB) reactivated its corporate sector purchase programme (CSPP) before the pandemic, European credit spreads did not follow the model like their US counterparts.

And Neither Are Volatility Spreads

Credit Spread Model Suggests Credit Is Fairly Priced

But what about the options markets? Do they offer any insight into the existence of a “Fed put” in US credit markets? After all, if investors anticipate less volatility in the future and smaller losses during stress events, then downside protection in options markets should be cheaper.

The following figures visualize the implied spread widening from CDX IG 3m 25d Payer swaptions compared with periods when actual CDX spreads increased by more than 50 bps. As credit spreads grew, the cost of protection rose. Since the last major credit market drawdown in 2020, volatility and the cost of protection had both stabilized. That is, until recently.

Indeed, we may be on the cusp of a major stress event. The macro picture is evolving, inflation remains a concern, and some indicators suggest an approaching recession. As credit spreads widen, the coming months may reveal quite a bit about market expectations around central bank interventions.

“Fed Put” Not Yet Reflected in the Cost of Insurance

Legal and Political Context

The Federal Reserve Act defines what lending activities the central bank can engage in, and in Section 14 it outlines what sorts of financial assets it can buy. Corporate bonds are not among the securities Federal Reserve banks are allowed to purchase in the secondary market. But the Fed has worked around this by applying its broader lending powers. Specifically, the Fed can lend to a facility that it creates, which can then purchase assets with those funds. The Fed used this technique during the GFC, including for the Commercial Paper Funding Facility (CPFF).

All the Fed’s lending activities must be “secured to [its] satisfaction,” and the assets in the facility should, in theory, serve as collateral. But since the facility will only fail to return loaned funds to the Fed if the assets do not perform, they do not constitute adequate collateral. Thus, in each of the two pandemic response facilities — the Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF) — funds provided by Congress under the CARES Act served as a first-loss equity investment. In protecting the Fed from losses, these investments ensured the central bank was secured to its satisfaction. Since the Fed established the two corporate credit facilities shortly before the CARES Act became law, the 23 March 2020 announcement noted that Treasury would use funds from the Exchange Stabilization Fund (ESF) to provide equity for the facilities.

In contrast to these explicit first-loss investments in Federal Reserve facilities, the Treasury backstop of the CPFF during the GFC was less formal. Under the time pressure of the Lehman Brothers default and the subsequent run on money funds, and absent clear precedent, the Treasury simply announced a deposit at the Fed with money from the ESF as an implicit first-loss contribution to the CPFF.

Section 13, Paragraph 3, of the Federal Reserve Act limits Fed lending to “unusual and exigent circumstances,” or during financial market crises and other periods of stress. These conditions applied to the PMCCF, which was intended as an alternative source of funds for corporations that couldn’t borrow from banks or in credit markets. These conditions include:

• A prohibition on lending to a single entity, so lending must be conducted through a program with broad-based eligibility.

• Program participants must demonstrate they can’t secure adequate credit from other sources.

• Participants may not be insolvent.

• The program or facility may not be structured “to remove assets from the balance sheet of a single and specific company, or . . . for the purpose of assisting a single and specific company avoid bankruptcy.”

• A stronger oversight role for Congress via detailed and timely reporting requirements.

• Prior approval of the Treasury Secretary for establishing an emergency lending facility.

With the Dodd–Frank Act of 2010, Congress added these conditions to the Federal Reserve Act as a way of keeping the Fed from acting unilaterally in future crises. For example, these conditions would preclude an AIG-style bailout. In addition, the Treasury Secretary approval requirement would help ensure that elected officials, working with a congressionally confirmed cabinet member, could influence and oversee the creation and design of any emergency lending facilities.

The 2020 pandemic suggests the Dodd–Frank Act may have strengthened the Fed’s policy response. Treasury Secretary Steven Mnuchin’s formal approval of Fed facilities, combined with Dodd–Frank’s enhanced reporting requirements and restrictions on the facilities’ structure, may have given Congress more confidence to allocate funds as potential first-loss investments. With backing from the Treasury and Congress and large equity investments from the CARES Act, the Fed expanded the size and scope of its policy response, particularly the PMCCF and SMCCF. The result was a “bazooka” approach that provided the markets with overwhelming support and promptly restored investor confidence. Eligible corporations would have virtually unlimited access to the Fed’s balance sheet if they needed it.

While the Fed only needs the Treasury Secretary’s approval to initiate a corporate credit facility, the Fed and administration have good reason to prefer congressional authorization of the funds to backstop that facility. Congressional support provides political cover and unlocks the facility’s larger potential with a more significant first-loss piece. The Treasury employed an alternative approach during the GFC, making de minimis, token first-loss contributions to facilities through the ESF. Why only token contributions? Because the ESF was designed to support the exchange value of the dollar in a currency crisis. The resulting facilities were adequate to the task during the GFC but would have been insufficient early in the pandemic.

Unlike the Fed, the ECB has clear legal authority to directly purchase corporate bonds in the open market and did so well before the pandemic in an effort to counter anemic growth and deflationary headwinds in the eurozone. Though neither central bank faces legal restrictions on lending to high-yield companies, both set the criteria for eligible securities, and with the exception of the Fed buying some fallen angels and high-yield exchange-traded funds (ETFs), both have limited their purchases to investment-grade corporate credits.

Can We Put the Central Bank Put to Rest?

We find no conclusive evidence of an enduring Fed put for US corporate bonds in the wake of the Fed’s extraordinary actions in 2020. Credit spreads and volatility remained low throughout 2021 but stayed within their historical range and in line relative to fair value models. The option skew was steeper than would be anticipated if a Fed put were influencing credit markets. Moreover, recent spread widening is largely consistent with a slowing economy.

This could mean that market participants understand that the Fed only stepped in during an unprecedented crisis and will stay out of a more run-of-the-mill recession, or that they believe inflation will limit the Federal Open Market Committee (FOMC)’s appetite for easing financial conditions in a slowdown. The market may also be influenced by the Fed’s legal and political constraints. If Treasury Secretary approval is required before it can act, the Fed may not want to purchase corporate debt without an equity contribution from the Treasury. Additionally, scaling up a program that could backstop the investment-grade market would likely require a more sizeable first-loss contribution through legislation and the allocation of taxpayer funds.

The Fed has always sought to avoid direct interference in the allocation of credit in the economy. As long as markets remain orderly and spreads are consistent with changing economic expectations and default and recovery rates, the Fed is not likely to purchase more bonds in the future. By quickly unwinding its corporate bond holdings in 2021, the Fed underscored its aversion to credit market intervention. As a consequence, the market may perceive a high bar for similar actions in the future.

There is circumstantial evidence that the ECB may have had a more enduring effect on euro-area credit markets. Since the ECB’s first intervention in 2016, the median spread for BBB-rated corporates as well as spread volatility have been lower than during the pre-intervention period. In addition, at the height of the COVID-19 market crisis in March 2020, euro-area investment grade spreads remained rich relative to modeled spreads. The ECB had already resumed corporate debt purchases in the fourth quarter of 2019. That combined with the lack of legal or political barriers to further actions may have created the expectation that the ECB would increase its corporate bond purchases to ensure the flow of credit to businesses.

Still, there is no clear-cut evidence that expectations of future ECB interventions are influencing corporate credit valuations. There are other reasons why BBB spreads have generally been narrower and spread volatility lower. First, despite a pause for most of 2019, the ECB has bought corporate bonds continuously since 2016 without any meaningful periods of risk aversion and volatility in European credit markets prior to the pandemic. Prior to 2016, however, the ECB navigated the GFC and the European sovereign debt crisis. ECB credit interventions have also coincided with other unconventional monetary policies that have lowered interest rates and further catalyzed a search for yield. These include interest rate cuts that took the ECB’s deposit rate even further into negative territory and the ECB’s first foray into sovereign QE in 2015. (From 2016 to 2019, the rate at the ECB’s deposit facility averaged –40 bps and the 10-year German bund yield averaged 0.19%. These compare with 86 bps and 257 bps, respectively, over the previous decade, according to MacKay Shields data.)

While the data doesn’t indicate market participants expect direct Fed support for corporate bonds in a future recession, such expectations may only reveal themselves as a crisis approaches. In the meantime, we should monitor how spreads, model valuations, and option prices evolve, particularly as investors weigh whether monetary tightening amid high inflation will lead to a downturn. The actions of corporations and rating agencies also deserve attention. Some firms may seek to improve their rating profiles ahead of a recession in order to be “in scope” for an anticipated Fed purchase program. Similarly, rating agencies might communicate how future central bank corporate bond purchases could influence their current credit risk assessments. And finally, central banks may comment on what conditions, if any, could lead them to reactivate their credit facilities.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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