Fed Should Draw the Line at Backstopping Junk Bonds

(Bloomberg Opinion) -- I’m just going to nip this line of thought in the bud right now: The Federal Reserve should not provide any sort of outright backstop to the U.S. high-yield bond market, no matter how bad things may get for lower-rated companies.

I bring this up not because there’s any reason to believe the central bank is on the brink of enacting such a facility but rather because credit-rating companies are updating their projections of just how many speculative-grade companies might fold because of the economic standstill brought about by the coronavirus outbreak. Moody’s Investors Service released a report on Friday that said a sharp but short-lived downturn would increase the global default rate among junk-rated borrowers to 6.8%. A recession on par with the previous one would mean a 16.1% default rate in a year, and something even worse would bring about a whopping 20.8% rate of failure.

Even the first scenario would be a shock to high-yield investors who for a decade have become accustomed to defaults in the low single digits and largely confined to an obviously distressed industry such as energy and retail. The wide range of outcomes is one of the reasons that I deemed junk bonds and leveraged loans “losers” among fixed-income assets in a column last week, in contrast to U.S. Treasuries, agency mortgage-backed securities and investment-grade corporate bonds.

Of course, one trait shared by the winners is that the Fed has signaled outright support for them. In the case of Treasuries and mortgage securities, it’s typical quantitative easing. But high-grade corporate bonds represent an entirely unprecedented endeavor. It’s so novel, in fact, that Jim Bianco, president and founder of Bianco Research, wrote a Bloomberg Opinion column arguing that the federal government is effectively nationalizing large swaths of the financial markets.

On the other hand, buying corporate bonds is old hat for the European Central Bank. While the Fed has set limits that allow its facilities only to add debt maturing in four or five years, the ECB can purchase securities that are due in up to 30 years. That’s an entirely different ballgame as far as projecting default risk. The ECB has no issue with adding negative-yielding debt, either. For those who might have missed it stateside, Siemens AG issued two-year euro bonds in August that priced to yield -0.3%, the most negative-yielding corporate debt sale of all time. It’s rated single-A.

“Investors may try to push back on some of the initial deals, but within a few months they will be considered relatively normal structures,” JPMorgan Chase & Co. strategists wrote at the time.

The backdrop of finding it normal to effectively pay companies to own their debt is important context for my Bloomberg Opinion colleague Marcus Ashworth’s column last week, titled “Junk Bond Investors Need a Little Love Too.” He rightly points out that the ECB’s measures to support bank lending don’t always reach where they’re needed — like speculative-grade companies that might fold without market access. That, in turn, could lead to widespread job losses and inhibit an economic recovery. The conclusion: “The central bank should think seriously about widening the remit of its corporate sector purchasing program to include junk bonds.”

The ECB might very well consider it. Nothing would surprise me at this point. For the Fed, though, it should be an easy decision: hard pass.

Credit ratings still need to mean something. I wrote last week about how the impending wave of fallen angels — those companies downgraded to double-B from triple-B — won’t be propped up by the Fed’s new credit-market facilities. Since that column, Ford Motor Co. became the largest such fallen angel of this cycle, with its $35.8 billion of debt headed into the high-yield index this week. I could almost hear the outcry: “Ford was investment grade before the coronavirus outbreak, which was totally out of its control. Why should the company be punished like this?”

It likely won’t be the last household name to drop into speculative grade, given how many of them gradually descended into the triple-B tier during the economic expansion. If this shock forces some finance officers to reconsider whether triple-B ratings are optimal, that’s not such a bad outcome.

Similarly, reaching for yield needs to have consequences. Investors at one point in December demanded just 38 basis points of extra yield to own double-B bonds instead of those rated triple-B. That spread reached 400 basis points last week. The difference between triple-C and single-B yields climbed to 819 basis points on March 24, from 426 basis points in early February.

Those kinds of moves are painful for U.S. high-yield funds, no question. But I’d wager that money managers would rather deal with these repricing episodes than to be in the shoes of their European counterparts, some of whom bought euro junk bonds from French packaging company Crown European Holdings SA at a 0.75% yield in October. That was a record low, as Ashworth pointed out.

Simply put, the Fed shouldn’t save every company, nor every investor’s position. In an ideal world, Chair Jerome Powell would most likely have preferred to go no further than the 2008 playbook of purchasing a vast amount of securities that have government guarantees. When that didn’t work, he dipped into short-term commercial paper, as was done before. And when that was insufficient, the central bank launched its new credit facilities. That unfroze the investment-grade market.

Whether that thaw makes its way to junk bonds is up to private investors. In hindsight, some securities will seem like bargains. Bank of America Corp. strategists, for their part, see spreads of 1,000 basis points as generally good value, while “at 1,200 bps it would be great value, and at 1,500 bps it would be an extremely rare opportunity.”

These types of evaluations are a crucial element of well-functioning capital markets. Unfortunately, when the going gets tough, some investors would rather have central banks provide a cheat sheet than do their own homework on which companies will survive and which will falter. The Fed should resist any temptation to lend a hand.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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