The Federal Reserve recently announced that it will expand its corporate bond buying activities to include the bonds of individual companies.
This marks just the latest step in an unprecedented program designed to support the credit markets in the wake of the March collapse. Previously, the U.S. central bank was purchasing corporate debt via bond ETFs through its secondary market corporate credit facility, which it will continue to do. Now, it looks like the Fed will become a debtholder of individual U.S. corporations as well. Here’s what the implications of this policy could be.
Does the Fed know how to value bonds?
On the face of it, it’s not such a big change for the Fed to go from bond ETF purchases to individual companies - this was within the mandate set up in March 2020. However, what is different is the Fed signalling that it is now willing to actively pick and choose which businesses to support.
This raises some pretty tricky questions. Typically, credit investors set themselves a goal of buying undervalued securities - trying to buy a dollar for 75 cents, so to speak. However, it’s not like the Fed has a staff of credit analysts on board that would help them do this. Sure, they could hire some if they wanted, but it’s not the goal of the central bank to act as the market’s value investor. If anything, the Fed is looking to buy a dollar for a dollar or more, and by doing so help highly leveraged businesses get through the post-lockdown doldrums.
This raises a further question - what is going to happen to these bonds held on the Fed’s balance sheet? Is the Fed going to make money on these purchases? And if not, where are the losses going to accrue?
Endgame
There does seem to be an endgame plan here. The Fed has (for now) said that it won’t buy bonds with a longer duration than five years, and its intention seems to be to hold these individual bonds to maturity. This is significant because the Fed presumably wouldn't want to spook the credit markets by selling these bonds. This is one advantage of buying corporate bonds directly rather than via ETFs - in the latter case, the fund keeps buying new bonds to keep the maturity constant.
However, if we have learned anything about ‘temporary’ monetary interventions since 2008, it’s that markets can quickly become addicted to stimulus. The long-term consequences of this are already materialising. In the late 1980s, the share of zombie firms (companies that are unable to service their own debt) in developed economies stood at just 2%. By 2012 it stood at 12%. A recent Deutsche Bank research note put the current share of zombie firms in the United States at 18.9%.
The longer that our central banks put off the inevitable tightening, the more painful it will be when (or if) they finally pull their support for these businesses. Already, it looks like the removal of the Fed backstop would lead to widespread bankruptcies. In the long run, the economy will be better off if the Fed pulls the plug on these failing businesses. Capitalism only works if bad companies are allowed to fail.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Carl Icahn Reflects on His Early Experience of Losing Money
- Bill Ackman: Index Funds Will Take on a More Activist Role
- Bill Ackman on What He Learned From Warren Buffett and Charlie Munger
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
