The Fed Triggered an Insatiable Demand for the Riskiest Corporate Debt

Mish

Demand for corporate debt has offered lifelines to struggling firms that can borrow at interest rates once reserved for the safest type of bonds.

Junk Bond Borrowing Binge

A Borrowing Binge Reaches the Riskiest Companies.

Companies such as hospital operator Community Health Systems Inc. and newspaper publisher Gannett Co. have issued a record $139 billion of bonds and loans with below- investment-grade ratings from the start of the year through Feb. 10, according to LCD, a unit of S&P Global Market Intelligence. More than $13 billion of that debt had ratings triple-C or lower—the riskiest tier save for outright default—about twice the previous record pace.

Despite the onslaught of new bonds, riskier companies can now borrow at interest rates once reserved for the safest type of debt.

The most striking aspect of the current lending boom is its timing. Typically, it can take years after recessions for the market to reach its present level of exuberance, analysts said. In this case, it has taken less than 12 months and has arrived just as economic data have revealed a winter slowdown in the recovery.

In recent weeks, three businesses have financed dividends to private shareholders by issuing PIK toggle notes—bonds that give the issuer flexibility to pay interest in additional bonds rather than cash. Such deals are hallmarks of hot credit markets, rising to prominence in the years leading up to the 2008-2009 financial crisis.

“The way the market is viewing this right now is basically saying, if all these triple-Cs can access funding, they’re not going to default,” said Oleg Melentyev, head of U.S. high-yield strategy at BofA Global Research.

The problem, he said, is investors are “hoping that this argument will work longer than it probably will.”

Bond Ratings

Bond Rating Comparison2

Investors are plowing into garbage just above default. 

Q: Why?
A: Fed Triggered Mania

There Are No Hawks on the Fed, Only Ostriches

On January 15, I commented There Are No Hawks on the Fed, Only Ostriches

Not to worry, “We’ll let the world know,” when we spot inflation says Powell who cannot see the big pink elephant standing right on the Fed's table.

The immense asset bubbles in the stock market, housing market, and bond market, provide ample evidence of inflation.

Instead, the Fed and most economists view the CPI, a fatally flawed measure, as representative of inflation.

The result of their head in the sand approach is three consecutive asset bubbles in 20 years, with increasing amplitude.

Fed's New Facility Will Buy Junk Bonds With 7-1 Leverage

On June 15, 2020 I noted Fed's New Facility Will Buy Junk Bonds With 7-1 Leverage

Moral Hazard

With highly questionable legality on top of a 100% certain moral hazard, here are the details of the Fed's new Secondary Market Corporate Credit Facility

Credit Facility Terms

  • The issuer was rated at least BBB-/Baa3 as of March 22, 2020, by a major nationally recognized statistical rating organization (“NRSRO”). If rated by multiple major NRSROs, the issuer must be rated at least BBB-/Baa3 by two or more NRSROs as of March 22, 2020.
  • An issuer that was rated at least BBB-/Baa3 as of March 22, 2020, but was subsequently downgraded, must be rated at least BB-/Ba3 as of the date on which the Facility makes a purchase. If rated by multiple major NRSROs, such an issuer must be rated at least BB-/Ba3 by two or more NRSROs at the time the Facility makes a purchase.
  • The issuer has not received specific support pursuant to the CARES Act or any subsequent federal legislation and must satisfy the conflicts of interest requirements of section 4019 of the CARES Act.

Leverage

  • The Facility will leverage the Treasury equity at 10 to 1 when acquiring corporate bonds of issuers that are investment grade at the time of purchase.
  • The Facility will leverage its equity at 7 to 1 when acquiring corporate bonds of issuers that are rated below investment grade at the time of purchase and in a range between 3 to 1 and 7 to 1, depending on risk, when acquiring any other type of eligible asset.

Not Remotely Legal

Not only is the facility illegal, it's a moral hazard asset prices support system that keeps zombie corporations alive.

Mish

Comments (23)
No. 1-17
Doug78
Doug78

Too much cash plus a dearth of good projects that give a decent return on cash flow equals cash going into quoted assets that go up in price because of excess cash that is there because of a dearth of projects that give a decent return on cash flow.

One-armed Economist
One-armed Economist

More "Party on" - until we can't...

TCW
TCW

Create inflation so the poor becomes poorer --> democrats now have a platform for election by promising to raise minimum wage and benefits --> democrats are elected, minimum wage and benefits raised --> cycle.

Sechel
Sechel

insatiable demand for risky bond and Yellen about to flood the maket with cash drivi rates even lower. not only is it confusing but it looks like a recipe for disaster

https://finance.yahoo.com/news/yellen-shift-vast-treasury-cash-100000816.html#:~:text=Yellen%20Shift%20on%20Vast%20Treasury%20Cash%20Pile%20Poses%20Problem%20for%20Powell,-article&text=The%20move%2C%20which%20aims%20to,grip%20over%20money%20market%20rates.

Yellen Shift on Vast Treasury Cash Pile Poses Problem for Powell
Yellen Shift on Vast Treasury Cash Pile Poses Problem for Powell

(Bloomberg) -- Treasury Secretary Janet Yellen is giving Federal Reserve Chairman Jerome Powell a bit of a headache when it comes to managing the money markets.Already low short-term interest rates are set to sink further, potentially below zero, after the Treasury announced plans earlier this month to reduce the stockpile of cash it amassed at the Fed over the last year to fight the pandemic and the deep recession it caused.The move, which aims to return its cash position at the central bank to more normal levels, will flood the financial system with liquidity and complicate Powell’s effort to keep a tight grip over money market rates.“All this cash from the Treasury’s general account will have to go back from the Fed and into the market,” said Manmohan Singh, senior economist at the International Monetary Fund. “It will drive short term rates lower, as far as they can go.”While the Fed has pushed its benchmark overnight policy rate down to nearly zero to aid the pandemic-inflicted economy, a drop in short-term market rates into negative territory could prove disruptive, especially for money market funds that invest in short-dated Treasury securities. Banks may also find themselves hamstrung by effectively being forced to hold large unwanted cash balances at the central bank.The Treasury’s decision -- unveiled at its quarterly refunding announcement -- will help unleash what Credit Suisse Group AG analyst Zoltan Pozsar calls a “tsunami” of reserves into the financial system and on to the Fed’s balance sheet. Combined with the Fed’s asset purchases, that could swell reserves to about $5 trillion by the end of June, from an already lofty $3.3 trillion now.Here’s how it works: Treasury sends out checks drawn on its general account at the Fed, which operates like the government’s checking account. When recipients deposit the funds with their bank, the bank presents the check to the Fed, which debits the Treasury’s account and credits the bank’s Fed account, otherwise known as their reserve balance.Dollar PressureMarket pros are trying to parse out the implications of what could be an unprecedented surge of liquidity. Some forecast downward pressure on the dollar. Others predict buoyant stock and bond prices. Still others see it mostly as a non-event -- except when it comes to the money markets.When ex Fed chair Yellen was nominated to become Treasury secretary, many analysts saw that as presaging very close knit ties between her department and the central bank. But there are limits on how far that can go, given the institutional imperatives of each organization.In preparing to lower its cash hoard at the central bank to $500 billion by the end of June from around a gargantuan $1.6 trillion now, Treasury is merely returning to a more normal modus operandi.“Treasury had just been delaying the day of reckoning for the Fed,” said Lou Crandall, chief economist at Wrightson ICAP LLC.Most Fed officials judge they have the instruments to deal with rising reserves, according to the minutes of their Nov. 4-5 meeting.But that doesn’t mean they won’t have to make some difficult decisions about the Fed’s interest rate tools, its bank leverage rules and possibly even its asset purchases.Tweak IOERIn an effort to provide a floor for the money markets, the central bank could lift the rate it pays on excess reserves parked at the Fed by banks and on its reverse repurchase agreements, from 10 basis points and zero, respectively. Tweaking these administered rates is something the Fed has done before.“If the Fed decides that it wants overnight rates to move away from zero, the most effective approach in my view would be to raise” those two rates together, said former New York Fed official Brian Sack, who is now Director of Global Economics for D. E. Shaw & Co.But that decision -- which could be made at next month’s policy making meeting -- would come as officials try to convince markets that they’re not about to reduce support for the economy. While any rate rise would be portrayed as a technical adjustment, there’s a risk investors wouldn’t see it that way.“The aesthetics of having to hike these rates, I’m not sure how well the market will digest that,” said Tom Porcelli, chief U.S. economist at RBC Capital Markets in New York. “It might be complicated.”What to do about the supplementary leverage ratio the Fed and other regulators impose on banks is also tricky. In order to ease market strains in March, the Fed temporarily exempted banks’ holdings of Treasuries and reserves from the ratio’s calculation. That exemption expires on March 31, just as banks’ cash balances at the central bank will be ramping up.Fed policy makers say they don’t want the exclusion, which has already been in place for about a year, to be permanent. If they do opt to temporarily extend it further, they’ll want to get agreement from rule makers appointed by President Joe Biden who may be less inclined to go along.Leverage RestrictionsIf the exemption lapses instead, banks might run the risk of bumping up against the leverage restrictions, especially as they’re obliged to hold a greater and greater level of reserves.Economists are divided over how disruptive that would be.Jefferies LLC economist Tom Simons said that banks haven’t made as much use of the exclusion as expected, so rolling it back shouldn’t have a significant impact.“It’s going to be a band aid that needs to be ripped off at some point,” he said. “Now is probably a good time to do it.”Others see a potential bond market decline if the rule snaps back as banks sell Treasuries to meet leverage restrictions and make room on their balance sheets for the increasing number of reserves they must hold.“The concern is that it would further impair banks’ willingness to make markets in Treasuries, to hold Treasuries, and to extend repo financing so that others can hold Treasuries,” said former Fed official Bill Nelson, now chief economist at the Bank Policy Institute that represents the industry.At their November meeting, Fed officials discussed another possibility for dealing with the bulge in reserves: adjusting their asset purchase program. But economists see that as a last resort, given how sensitive investors are to any changes on that front.The coming surge in reserves as the government slashes its cash pile will add to a flood of liquidity already in the system from the Fed’s ongoing bond buying.“This is going to bring to a head the consequences for the money markets of the dramatic increase in the Fed’s portfolio,” Crandall said.For more articles like this, please visit us at bloomberg.comSubscribe now to stay ahead with the most trusted business news source.©2021 Bloomberg L.P.

Doug78
Doug78

Mish, since the Secondary Market Corporate Credit Facility came into being in June 2020 as a result of the pandemic do you expect it to become permanent or quasi-permanent even when conditions normalize?

caradoc-again
caradoc-again

Watch HYG, when it breaks down it is a signal.

With care, sometime, there will be a chance to lock in high rates even allowing for defaults.

Great opportunity will arrive if you have the cash available.

KidHorn
KidHorn

Junk yields will keep going down. Once the FED starts buying an asset class, the yield approaches 0. This is what happens when you have an entity buying securities that isn't trying to make a profit.

Still a better investment than tesla. A company that has never figured out how to sell cars for more than they cost to make and has a mkt cap > the next 6 car companies combined. tesla is going to be the poster child for the current bubble.

Frilton Miedman
Frilton Miedman

My POV, for 4 decades gov has implemented tax, deregulatory, foreign trade policies that have only benefitted the top income earners, shareholders, C-suites.

The Fed has had to accommodate the resulting household & government debt with increasingly lower rates.

My answer, regulate market (and housing) speculation, or modify rates on market activity/margin, increase income tax for top brackets, do something about household wages, and only then can the Fed tighten.

There are babies in the bath water folks, a lot of 'em.

nzyank
nzyank

Not just corporate debt - lots of other assets as well. Interesting that gold has massively underperformed in comparison...

Lots of wealth floating around looking for a home while most stand by and watch. Inequality has a perverse effect on markets.

Six000mileyear
Six000mileyear

The 10 yr US bond sold off hard today. This is feeling like a yield breakout with the 50 and 200 day moving averages trending UP. Yields have not surpassed the pre-COVID rates, but most of the lending has occurred below today's rates, so there is no refinancing those stimulus loans through the market.

Casual_Observer
Casual_Observer

This is all just a bailout of pension funds and other instruments. Everyone knows the this now and we just pretend. There is a lot of pretending going on but how else can a central bank take care of 7B+ people. Corruption is why we win.

truthseeker
truthseeker

Do you think the Fed will keep letting the bond market sell off as rates go up to maybe take down bitcoin? If so time to short everything I would think.

bluestone
bluestone

Businesses that are otherwise profitable can have drop down, immediately dead heart attacks from cash flow issues. For the UK one of the recessions was worsened because of chaining of delayed (because of cash flow) supplier payments causing cascading bankruptcies from cash flow issues.
The fed only has a shotgun, a broad brush, so the anticipation must be a funding crisis. After all who would want to hold corporate debt during a pandemic, far better to keep the powder dry for fire sales after. Fed pressing pause on "creative destruction"

ColoradoAccountant
ColoradoAccountant

In my career, my defined benefit pension went from 105 percent funded to 51 percent funded. A combination of politicians who are cash basis instead of accrual basis, and a Federal Reserve that doesn't understand that gold is what kept them from being slaves of Congress.


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