In the wake of the 2008 financial crisis, then-u.s. Treasury secretary Henry paulson wrote “the edge of the cliff,” a book reflecting on the steps the United States has taken in the economic crisis. The financial crisis of 2008, the controversial issue of whether the U.S. government and its federal reserve should bail out commercial Banks, and the collapse of lehman brothers once made sympathizers writhe.
Now, in the face of the crisis caused by covid-19, the trump administration and the federal reserve have already made up their mind to carry out unlimited QE. It is not only the five quotas, but also the bottom line. The purchase of corporate bonds by the federal reserve through belder is exactly the breaking of the boundary between the government and enterprises.
The question is what to do if the firms they bail out still end up bankrupt and the fed eats too many toxic assets. If the 2008 financial crisis was about America’s commercial Banks at the edge of the cliff, the federal reserve, the DE facto us central bank, is at the edge this time.
Hertz filed for chapter 11 bankruptcy protection Monday in wilmington, mass., in an effort to avoid a forced liquidation of the $19 billion car rental company’s 700,000 vehicles worldwide. — just 10 days after the federal reserve commissioned blackrock to begin buying secondary market corporate bonds.
The fed’s rescue was still ineffectual
As the fed’s SMCCF vehicle to support the functioning of the corporate bond market, the fed will not only buy investment-grade corporate bonds and “fallen angels” (recently downgraded to junk), it can even directly buy junk-bond etfs such as HYG and JNK. In its’ over $7 trillion ‘balance sheet released Thursday, the fed already has $1.8 billion in assets under its corporate-debt instruments, which include investment-grade bond etfs and a range of junk-bond etfs.
At a senate hearing on May 19, Powell again defended his decision to buy junk bonds. The fed chief said the move would avoid a “glaring disconnect” in the bond market, where the investment-grade bond market is doing well and the leveraged and non-investment-grade markets are struggling.
The problem lies in the purchase of junk bond etfs, including HYG, JNK and other junk-bond etfs, the largest in the market, which are equipped with Hertz car rental, which filed for bankruptcy in large amounts. HYG, which has a market capitalization of $23.3 billion, owns four Hertz bonds worth about $50 million. JNK, which has a market capitalisation of $11.5bn, owns three Hertz bonds worth about $30m. Both etfs hold bonds issued by Hertz in November and are already in a no-pay situation.
Companies have been on a borrowing binge, exceeding $1 trillion in less than five months
Us investment grade companies are issuing debt at a rapacious pace as the novel coronavirus pandemic pushes up cash demand.
Issuance of highly rated bonds reached $11.2 billion in 11 transactions on May 19, bringing the total for the year to $1.003 trillion, strategists at Bank of America said in a note. Companies have capitalised on a growing appetite for risk, issuing nearly $200bn in debt so far in May.
This year’s wave of debt issuance is far more intense than it was a year ago. For the whole of 2019, investment-grade companies issued $1.14tn in debt, according to the securities industry and financial markets association.
The corporate bond market has rebounded sharply from the lows set off by the covid-19 outbreak following the unprecedented intervention of the federal reserve. On March 23rd the federal reserve announced an expansion of its asset-buying programme to include corporate-bond etfs. The market for corporate bond etfs soared after the announcement, reversing two weeks of losses. The fed’s move supported the market and U.S. stocks through April and may. The announcement has also boosted inflows into investment grade bond funds and etfs in recent weeks.
The fed began buying etfs on May 12th. According to data released by the federal reserve on May 14, as of May 13, the balance of the secondary market enterprise credit facility (SMCCF) instrument was $305 million, that is, it bought $305 million of ETF within two days after the launch of the program. Overall, the fed’s balance sheet hit a record $6.93 trillion in the week ended May 13, up about $212.8 billion from the previous week.
The “fallen angels” descended on an unprecedented scale of downgrades
In recent days, the number of bonds being downgraded, such as Apache Corp and Service Properties Trust, has soared to unprecedented levels. Since the end of February, net downgrades (downgrades and upgrades) of investment-grade bonds have totaled $1.126 trillion.
By sector, bank of America notes that since the end of February, the bank/brokerage sector has seen the most downgrades in bonds ($258bn, or 28 per cent of the total), followed by the energy sector ($200bn) and the automotive sector ($160bn).
Large issuers accounted for most of the downgrades. Since the end of February, the top three issuers in the energy and auto sectors have accounted for 54% and 62% of the downgraded bonds, respectively. Bank of America expects more fallen angels to emerge in the future.
“Fallen angels” are bonds whose credit ratings have been downgraded from investment grade to speculative or “junk” status.
The number of “fallen angels” soared in the first quarter, driven by the covid-19 crisis and plunging oil prices. As of April 13, the number of potential ‘fallen angels’ — those with the lowest investment-grade credit ratings and a negative outlook of’ BBB - ‘- in the U.S. bond market was 96, up from 82 in March 2009 at the height of the last financial crisis, according to s&p.
Investors fear that if potential fallen angels are downgraded to junk status, it could push up their borrowing costs further and spark a wave of selling, as some investors have rules that don’t allow them to hold non-investment grade bonds.
Mohamed el-erian, allianz’s chief economic adviser, said recently that he believes the fed has gone too far in its efforts to buy high-yield bonds, and warned that this could leave some zombie firms swimming in troubled waters and requiring caution.
Mr Powell will be grilled on Friday
If the fed does not dispose of its holdings in time, the assets could even become Hertz’s equity once the company is restructured. This will certainly cause a series of legal disputes.
As early as in 2017, when the European central bank faced the “debt-for-equity” dilemma caused by the default of Stan international holdings, the then President Mario draghi quickly liquidated the relevant positions to avoid the subsequent controversy.
For the fed, which has a large exposure to corporate bond etfs, the next few months are bound to be more hertz-like than ever, and it may be difficult to “unwind” the position in a way that Powell is expected to address in a video address on Friday.
The problem is, if the fed doesn’t step in, it’s another iceberg, and the market will lose confidence again, and the avalanche will come again.
There is no such thing as a free lunch. The fed can only print dollars, not wealth. This time, the fed is on the brink of a precipice.
