The U.S. Federal Reserve apparently is here to close spreads. The central bank announced last week that it will use lending facilities to buy the bonds of some so-called fallen angels – or U.S. companies whose credit ratings are downgraded to junk status after March 22 – and some high yield exchange traded funds. Afterward, ICE Bank of America indices showed that the difference between the yields on BBB-rated debt, the lowest level of high grade, and the highest level of junk status narrowed by almost a fifth.
Supporting fallen angels may be a reasonable short-term compromise if there were to be a clear credit crunch. Around $2.5 trillion of U.S. nonfinancial investment-grade bonds – or around half of the total – were rated BBB as of last year, according to S&P Global Ratings. That’s more than double the U.S. nonfinancial speculative grade bond market. And Citibank reckoned up to $300 billion could fall into junk territory this year. Too much supply could overwhelm the market.
This activity is also supposed to be temporary, but neither the justification nor the timeline may be correct. Institutional investors don’t normally shed debt immediately after it’s downgraded. And while high yield spreads were briefly up threefold this year and new issuance was halted for a few weeks, yields started to fall and Yum! Brands snapped the dry spell when it raised $600 million in late March. So markets are operating.
And the Fed said its moves during the last financial crisis were short term, too, only that wasn’t the result. Ultra-low interest rates and bond market support begun during the crisis fueled a corporate debt binge that’s partly responsible for this BBB bulge – as nonfinancial corporate debt spiked to around $10 trillion in the 10 years to 2019, putting debt-to-GDP higher than before the crisis.
Fed Chair Jerome Powell may find unwinding lending facilities tricky. Ructions might occur whenever the Fed tries to normalize policy – like during the so-called Taper Tantrum of 2013. Ongoing support could mean thinner spreads, scant compensation for risk and chancier investments. If it isn’t careful, the Fed might end up having to clean up its own mess yet again.