Fed Expands Bond Buying to Now Include Junk Bonds
The Federal Reserve normally confines its bond buying to U.S. treasuries, and its buying corporate bonds is a big departure. Buying corporate junk bonds is even more so.
The Federal Reserve Bank of the United States normally only seeks to manage the economy by taking actions that either increase or decrease the country’s money supply, and one of the ways that they do this is through what is called quantitative easing or quantitative tightening, depending on whether the goal is to increase the money supply by easing or decrease it by tightening.
Most people do not have much of an understanding of how these things really work, but an easy way to see this is the old idea of governments printing more money and handing it out, or taking money out of circulation if the goal is to cool down the economy instead of jolting it more awake.
This isn’t the only reason why the Fed may undertake a program of quantitative easing, as during times of real crisis, such as we are facing now and faced during the last crisis, they also need to deal with the threat of a liquidity crunch.
An even bigger goal and issue than controlling money supply is to ensure that the world of financial transactions are not hampered too much by economic crises, and while this requires both monetary and fiscal stimulus to achieve, the Fed has certainly done its part by setting the overnight rate to zero and flooding the market with trillions of dollars of new money.
Depending on the circumstances, and especially in concert with massive fiscal stimulus packages such as we have just seen, this can be enough, but sometimes more is needed to preserve the level of stability that is required to not send us spiraling downward into a far more serious economic collapse.
The treasuries market had already been running hot enough, and with this issue being virtually world-wide, the safety of U.S. treasuries already has its own appeal. Just in case though, the Fed has decided to pour in trillions more into it, and this has certainly steadied these markets which were already quite overbought but remain so, this time for strategic reasons, for the sake of increasing the money supply.
This program does leave the corporate bond market to fend for itself, and if the economy was actually open, this additional money supply would stimulate demand enough to help this market out as well.
That doesn’t work so well when your business activities have been severely curtailed though, the predicament we find ourselves in now, and the Fed has seen fit to buy corporate bonds as well, to seek to prop these markets up as they started to fall on their face.
Companies find themselves borrowing at the best of times, and certainly need to do so during the worst of times, when their revenue has dried up and they need to keep things together. Most of this comes from their raising money by issuing corporate bonds, and given that their risk is higher now, it doesn’t do any good to set bank rates to zero in the hopes that these companies will now be able to borrow more cheaply from this, only to see their borrowing instead become a lot more expensive.
The underlying goal of the Federal Reserve’s monetary policy is to stimulate more borrowing when the need arises, and stimulate a lot more borrowing if that’s needed, as it is right now, and as we have clearly seen, normal quantitative easing isn’t always enough.
The Fed’s corporate bond buying actually seeks to accomplish two purposes, to help companies borrow at a cheaper rate as well as to look to benefit investors by seeking to stabilizing the secondary market for these securities. They don’t want to see the rates that companies pay to borrow become too high, but they also do not wish to see investors who have invested in these bonds, including some big institutions, get hurt too much by this, as this can have some significant ripple effects upon the economy.
This corporate bond strategy was originally limited to investment grade corporate bonds, mostly because they relatively safe, but it is the other type, called junk bonds, that is in even more need of help. If we had to pick, and we were looking to avoid turmoil, we’d be picking the junk bonds for sure because they are closer to what we really want to prevent, too many defaults and too many companies going under as a result.
When your company defaults on its bonds, it becomes insolvent and its assets are sold off to have bondholders collect at least a portion of the money owed to them. The losses that ensue can contract the economy greatly, as we saw in 2008, even though those were defaults of a different sort. Mortgage backed securities going into the toilet was bad enough, but this happening to large corporations on a wide scale can be even more dangerous.
Companies Will Need to Be Saved if We Wish to Save Ourselves
Just like we had to step in to save the banks, we have to step in and look to prevent a lot of corporate bond defaults, regardless of the particular risk that these bonds may represent. It’s not that we want to be throwing too much good money after bad, as if a company was already on the rocks anyway, nursing them back to health with public money just to see them die anyway isn’t such a great idea.
However, if the companies were otherwise in decent shape at least, and have been thrown into a real mess as a result of government directives, these are companies that are not only worth saving, but especially are given that this has happened to them by way of government action directly.
There are some politicians who agree that the current dire situation that these companies are in may not be their fault, but they still want them to pay dearly for this. That is both irresponsible and confused though, as this is like kidnapping someone and depriving them of a way to make a living, and then somehow thinking that this is partially their fault and they must therefore bear a significant part of the loss that ensued, or perhaps even all of it.
What isn’t discussed much is the deadweight economic loss that this will worsen, and while we will see plenty of that anyway, we don’t want to make this worse on purpose. It is actually imperative that we get things back to normal as soon as possible as far as healing the economy goes, and we do not want to create a big residual effect here where companies need to be paying back a lot of this money, leaving both them and us hampered for years past the point where this should have been over.
This is the real challenge with our recovery, and while the last crisis clearly was the fault of business, this one is not, and we cannot rightly treat them the same way.
The Fed has told us that nothing is off the table as far as their response to this crisis, and if people were surprised that they were willing to go big with corporate bond purchases, they will be even more surprised that corporate junk bonds are now on their shopping list. This makes a whole lot of sense though.
If we want companies like Ford, who have had a very strong presence in our economy since Henry started the company in 1903, to get through this mess without too much damage, we can’t just turn away from them. Ford’s bonds used to be investment grade, until they had to shut down their plants and have now been given junk status.
Ford and many other companies have been downgraded to junk now, and it would be folly to refuse to help them just based upon this, especially since this is our fault. Whether or not this shutdown was wise, it happened, and we have to ensure that we take responsibility for causing it and especially not to want to turn away from such iconic businesses because we think that they are too sick, and we made them so.
The Fed has now wisely reconsidered their position on buying junk bonds, although they do have the condition built in to their new strategy that a company needed to have an investment-grade rating on March 22, the day after the Fed rolled out their investment-grade corporate bond buying.
If anything, the date should be set even further out, as this crisis didn’t exactly start on March 22. A month earlier would make even more sense, when we really started to worry about this virus and stocks started to really tank. However, this is at least a good start.
Even though the Fed may say that this is all that they are doing, once they start buying junk bond ETFs, this will bring them into the realm of buying junk that was already junk. This doesn’t help the companies though, it only props up the secondary market, which may be a worthy goal in itself but is apart from the primary one of actually allowing these companies to borrow at more reasonable rates than junk status would provide.
Even more importantly, the Fed needs to keep a close eye on defaults that become immanent with these junk bonds, and make themselves the lender of last resort with at least some of these companies the way that they do with banks. This is not something that we necessarily want to do unless there is a real need, as efficient markets require a Darwinian approach of allowing only the fit to survive, but we can’t have too many of these deaths at once lest this takes us down with them to an unacceptable degree.
Our Economy is Very Sick Right Now and its Health Matters a Lot
As we continue to navigate the effects of this pandemic, we need to make sure that we take care of our economic health as well, and there may not have been a time since the Great Depression that Dr. Fed’s care has been more needed. This is a bigger threat than even the 2008 crisis, which was actually a pretty easy fix, and it is reassuring that the Fed has brought a doctor bag that is at least big enough to provide the right amount and right kind of treatment, within the limitations of what this economic health care can provide.
It is far from unlimited though, as is fiscal stimulus. It’s hard to do too much on the monetary policy side, but you can certainly overdo it on the fiscal side, and the idea that we can all live off borrowing against our future for too long is a very dangerous idea that is headed toward great calamity if not remedied soon enough.
The amount that the U.S. government can borrow is a fixed amount, and each trillion that we borrow now is a trillion we will not be able to borrow in the future. This can hasten the country’s economic death significantly if we are not careful, but an even bigger beat looms out there, one that can do us in right now if we wish, which is hyperinflation.
The easiest way to understand this is to go back to the money printing machine, and when a country prints more and more money, it is worth less and less. The only way to really equalize a shutdown is to just give people the money they would have made otherwise, and doing the same thing with companies, but that would require a bill so large as to make the $2.2 trillion we’ve earmarked already just an ante into the game.
The real payload from this would be after we finally recover, as we’d then be faced with massive inflation, where we’d be faced with the choice of either letting it running away and destroying our economy that way, or putting a lot of people out of work for long enough to beat this inflation out of the economy, which also comes at a big price but ultimately the lower of the two, even if this means creating a man-made depression.
Both scenarios would be very painful, but the one that throws us into a depression for a time would be the least painful of the two, as that one we would eventually recover from, even though it may take years. We cannot even imagine what destroying the U.S. dollar would bring, but calling this an economic holocaust wouldn’t be exaggerating things. The depression that would come from this would be several times worse as all of our wealth would be lost and our economy would be on a ventilator, or worse.
We do need all the help we can get in battling this, and having the Fed open up their minds enough to buy junk bonds is reassuring. We also hope ardently that cooler heads will prevail soon and we do not allow ourselves to continue to be so spooked by this virus that we cause damage so extensive that it may take years to recover from, if at all.
There is a lot on the line here, and how we respond to this health crisis once it does wind down will determine whether we take the hard or soft option, and the hard option is not one we can ever afford to choose.
If there is a silver lining to this, and it’s hard to find one with this one, it is with the hope that we may confine draconian economic constraints such as what we are still under more judiciously. This will probably require a harder lesson than we’ve learned so far, but that lesson is on the way, and hopefully we won’t choose to make it too hard and make this lesson far too costly to bear.
Chief Editor, MarketReview.com
Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.
Contact Ken: ken@marketreview.com
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