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John Engle
John Engle
Articles (529) 

Why the Fed’s Bond Buying Is a Recipe for Trouble

Interventions in the bond market could have unintended consequences

April 20, 2020 | About:

With its conventional monetary policy toolkit largely exhausted at the outset of the economic downturn, the Federal Reserve quickly turned to more idiosyncratic alternatives.

The central bank has begun facilitating the purchase of corporate bonds. The Fed is now in waters that have so far been uncharted by the U.S., and its interventions are coming under increasing scrutiny – especially as it plunges deeper into high-yield debt.

A stretched mandate

The Fed’s entry into corporate bond purchases, especially risky junk bonds, is unprecedented. On April 14, legendary bond investor Jeffrey Gundlach criticized the Fed for its dubious intervention in the high-yield bond market:

“The Federal Reserve is presently acting in blatant non-compliance with the Federal Reserve Act of 1913. An institution violating the rules of its own charter is de facto admitting that said institution has failed and is fundamentally broken.... Of course, the Federal Reserve will make some wonky semantic argument about why they are ‘technically’ in ‘compliance’. Just like the balance sheet expansion program last fall was ‘not QE’.”

It is a serious stretch to say that the Fed’s bond market actions are in full compliance with its legal mandate. Its workaround – using special purpose vehicles to fund bond purchases by the Treasury – may be in keeping with the letter of the law, but from my view, it is stepping outside the spirit of the law.

Credit quality breakdown

Bond markets rely on accurate and consistent risk pricing. Credit rating agencies like Moody’s Corp. (MCO) specialize in assessing the credit-worthiness of companies’ debt. The Fed’s foray into junk bonds has served to disrupt this functionality. According to Bloomberg’s Matt Levine on April 9, the Fed has effectively clipped the wings of credit rating agencies:

“The ratings agencies aren't taking a few months off, but as far as the Fed is concerned they are, because the Fed has decided to ignore their post-March-22 decisions.”

The Fed’s high-yield bond purchases have created liquidity and shored up near-term confidence, but they also threaten to undermine accurate risk pricing. Credit rating agencies have already created dangers themselves in recent years due to their embrace of increasingly relaxed rating standards. The Fed’s intervention may further deform the market’s ability to price credit risk accurately.

Sliding down a slippery slope

The Fed’s high-yield bond intervention is an extreme by any measure. It is a major departure from past responses, and it may put the Fed on a dangerous course. On April 14, Bloomberg’s Brian Chappatta explained the extent of the distortion created by the Fed’s bond market actions:

“It’s hard to interpret the high-yield ETF inclusion as anything other than taking a flamethrower to the somewhat frozen high-yield market and propping up prices. Junk-bond spreads tightened the most since 1998 in percentage terms on Thursday, while HYG itself surged 6.6%, the biggest rally since 2008. On Monday, bankers rushed to take advantage of the sudden shift, bringing deals on behalf of Burlington Coat Factory, Cinemark, Ferrellgas, Sabre and TransDigm. That’s not how healthy markets are supposed to work.”

The Fed risks creating a dangerous slippery slope with its entry into high-yield debt markets. Propping up bond prices will only serve to further distort the proper pricing of assets and risk, something that may prove impossible to unwind post-crisis.

Specter of moral hazard

The danger of widespread moral hazard may have also intensified, as Northman Trader’s Sven Henrich opined on April 9:

“The Fed’s message to the market today: If you are careless and invest in high risk debt we will bail you out. If you are prudent and hedged in any way given the risk environment we’re in we will destroy your hedges. The Fed is encouraging risky behavior and punishing prudence.”

Under such conditions, companies in the aftermath of the crisis may become accustomed to the heavy-handed Fed approach, which has allowed many of them to weather their credit crunches largely unscathed. High-yield investors have also escaped with their skins intact. Yet, these debt markets are meant to be high risk, high reward. Removing much of the downside via a veritable Fed guarantee could distort the risk-taking behavior of companies and investors going forward.

Verdict

The full consequences of the Fed’s entry into the bond market remain to be seen. However, wary analysts and commentators can already see dangerous fissures forming that could threaten the stability and integrity of credit markets – and all capital markets – going forward. That should be cause for concern among all investors.

Disclosure: No positions.

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About the author:

John Engle
John Engle is president of Almington Capital Merchant Bankers and chief investment officer of the Cannabis Capital Group. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin, a diploma in finance from the London School of Economics and an MBA from the University of Oxford.

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