ETFs providing exposure to USD high-yield bonds have rallied after the Federal Reserve announced it would expand its asset purchasing program to include them.
The Federal Reserve will include recent “fallen angels” as well as broad market high yield ETFs within its asset purchasing.
On Thursday 9 April, the $15.3bn iShares iBoxx USD High Yield Corporate Bond ETF (HYG US) and the $8.5bn SPDR Bloomberg Barclays High Yield Bond ETF (JNK US), the two largest ETFs to cover the junk bond space, each soared 6.5% on the news before ending the day up roughly 3.7%.
The Federal Reserve’s move to buy junk bonds and the ETFs that hold them highlights the institution’s resolve in supporting markets and propping up the US economy which has been slammed by the coronavirus-induced shutdown.
The US central bank had already deployed a number of tools in its arsenal including slashing short-term interest rates to effectively zero, scrapping reserve requirements for depository institutions, and embarking on a massive quantitative easing program covering US Treasuries, mortgage-backed securities, and investment-grade corporate bonds.
The inclusion of high-yield bonds within the Federal Reserve’s asset purchasing programs stands in contrast to its earlier statements which indicated it would limit its buying to investment-grade credit and related ETFs.
High-yield bond purchases will be conducted through the Federal Reserve’s two existing facilities – the Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF).
The former purchases newly issued corporate debt directly from firms in primary markets, while the latter focuses on bonds and credit ETFs trading in secondary markets.
Under the PMCCF, the Federal Reserve will focus on high-yield corporate bonds that were designated investment grade before 22 March but have since been downgraded – so-called “fallen angels”. Fallen angels that have crashed below a rating of BB- will not be eligible.
Under the SMCCF, the US central bank will purchase ETFs that provide broad exposure to the US high-yield corporate bond market. Both HYG and JNK fit the bill in this regard.
The Federal Reserve has stated it will limit the extent of its purchasing to 10% of an individual issuer’s bonds and 20% of any ETF’s total shares.
The Federal Reserve’s support for fallen angels has been well-received, relieving fears about how the high-yield market would absorb the onslaught of downgrades. Analysts note the central bank’s actions will not help prevent issuers rated junk before the crisis from running out of cash and declaring bankruptcy. Many agree, however, that highly leveraged firms that were struggling to turn a profit might not be worth saving.
The Federal Reserve’s move to buy broad market junk bond ETFs has raised a few eyebrows though. Some analysts have criticized the central bank’s decision to bolster the entire high-yield market, noting that it may distort investors’ risk perception, leading to a misallocation of capital.
In a memo to clients, Howard Marks, co-founder of Oaktree Capital Group, a prominent buyer of distressed debt, wrote, “Markets work best when participants have a healthy fear of loss. It shouldn’t be the role of the Fed or the government to eradicate it.”
Marks admits that the severity of the coronavirus’s impact on the global economy necessitated a swift and pronounced response from officials; however, he states that the action taken by the Federal Reserve also “poses a threat to the traditional concept of American capitalism, as the Fed and Treasury become the leading lenders to US businesses.”