1. How to use GuruFocus - Tutorials
  2. What Is in the GuruFocus Premium Membership?
  3. A DIY Guide on How to Invest Using Guru Strategies
Margaret Moran
Margaret Moran
Articles (258) 

The Real Cost of the Fed’s Bond-Buying Program

The program is price support for now, but the game could change

June 16, 2020

Almost three months after the U.S. Federal Reserve announced that it would begin purchasing the bonds of publicly traded companies, thus putting a floor under credit and equity prices alike, it announced on June 15 that it will begin buying the bonds of individual companies.

Up until now, the Fed’s bond buying has been limited to exchange-traded funds, which are ostensibly a less biased method of investing. After all, the Fed’s goal here is not to become a major credit facility for any one company. For now, it is mainly aiming to prop up investor sentiment and help highly leveraged companies avoid major impacts on operations.

As for which specific companies it plans to buy the debt for, the Fed has not yet specified. According to a press release, it “will begin buying a broad and diversified portfolio of corporate bonds to support market liquidity and the availability of credit for large employers.”

At first glance, it seems like these measures are merely extensions of the Fed’s open-market operations. However, both the corporate bond-buying program in general and the new move to invest in the credit of individual companies specifically mark changes that could become a permanent fixture of Fed policy, changing the game for investors.

How much debt can the Fed buy?

So far, the Treasury has given the Fed $75 billion for the corporate bond-buying program, which it will leverage 10-to-1 to buy up to $750 billion worth of corporate debt in the form of both ETFs and individual company bonds. The quality of debt approved for purchase ranges from investment grade to junk, though junk will only benefit from ETF purchases and not individual purchases (for now).

Deploying all $750 billion would lead to the Fed owning approximately 5.17% of the country’s $14.5 trillion in corporate debt. This may not seem like much at first glance, but it would represent an over 5% increase in potentially less than a year.

The Fed only earns approximately $55 billion on average every year, mainly through investments in domestic and foreign treasury bonds, so it certainly can’t keep this up indefinitely without additional funding from the Treasury and thus additional risk of inflation and a weakening U.S. dollar.

Market share

Another question is how much debt the Fed will decide to buy. In testimony before Congress, Fed Chairman Jerome Powell said, “It’s out of an excess of caution to preserve these gains for market function by following through,” indicating that the central bank’s actions are in direct response to the spike in equity markets and the desire to keep the equity price increases in place.

“It’s really going to depend on the level of market function,” Powell continued. “If the market function continues to improve, then we are happy to slow or even stop the purchases. If it goes the other way, we will increase.”

This indicates a shift toward attempting to put a floor under both credit issuance and share prices, regardless of the cost. In this case, the cost is that markets are now directly tied to Fed ownership. If the Fed were to sell its corporate bonds, it would cause panic in both credit and equity markets, thus counteracting its goal of supporting prices.

With interest rates expected to remain near zero percent through at least 2021 and probably longer than that according to many analysts’ analyses, equity buying could become the Fed’s new weapon of choice to prop up corporate spending and equity prices during market downturns. If it were to keep it up long enough with government support, potentially even following in the Bank of Japan’s footsteps and buying stocks, it could eventually own significant portions of specific businesses.

Businesses whose main creditor is the Treasury-owned Fed may very well come under the government’s thumb in some form or fashion. Though this might not be the intention at first, it might be difficult to resist exercising legal and financial leverage over businesses once it is obtained.

Government-backed

Increased government interference in businesses has high potential to change the environment for investors in unpredictable ways. This is one of the main reasons why successful investing strategies differ from country to country, along with regulatory risk, political risk, etc. Think of the way certain publicly traded and state-owned companies in China, Saudi Arabia and several European countries behave.

A close (but not exact) example of this in the U.S. is how government subsidies helped the “Big Six” U.S. publicly-traded oil companies achieve much higher profitability than their peers, strengthening their balance sheets and profitability and causing their share prices to skyrocket during the shale oil boom.

The fact of the matter is that a government-backed company is an almost guaranteed success due to access to vast amounts of liquidity, at least until the government withdraws its support. The key difference between subsidies and ownership is that subsidies can be quietly cut, while the Fed dumping the debt of large corporations on the open market would not end well for equity markets.

Conclusion

Much like how the federal funds rate has been in a downtrend to zero over the past century, the Fed’s bond buying has the potential to become a permanent part of its fiscal policy. This seems likely to happen as soon as it becomes too dangerous for the Fed to dump bonds without investors fleeing equity markets.

The consequences of long-term and increasing Fed ownership of corporate debt would include greater government involvement in and control over large publicly traded companies, which would certainly change the way investors approach those companies and the markets in general.

Of course, at the moment, the impact of the Fed’s actions on markets is mostly psychological, with its involvement causing companies to issue more debt and investors to spend more on stocks and bonds. This can all be considered part of normal open market operations, though with corporate debt reaching at least 67% of gross domestic product as of the end of May, it seems increasingly likely that the Fed’s pledged involvement in the bond market will become a self-fulfilling prophecy.

Read more here:

Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.


Rating: 5.0/5 (7 votes)

Voters:

Comments

dr.ramymagdysh
Dr.ramymagdysh - 1 month ago    Report SPAM

Great article, thanks.

I think the most scary part here is a threat to democracy. When the Fed starts buying debt of large companies it will start to have leverage over them -think of yourself trying to please your debtor. Which would be a powerful tool for governaments to manipulate major or all companies towards what they want. Thus controlling the economy.

On the other hand, buying debt of US companies with easily printed money will lead to inflation and, worse even, loss of global trust in the Dollar.

The Fed here is treading on a very fine rope.

Please leave your comment:



Performances of the stocks mentioned by Margaret Moran


User Generated Screeners


pjmason14Momentum
pascal.van.garsseHigh FCF-M2
kosalmmuse6
kosalmmuseBest one1
DBrizanall 2019Feb26
kosalmmuseBest one
DBrizanall 2019Feb25
kosalmmuseNice
kosalmmusehan
MsDale*52-Week Low
Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)