Federal Reserve Goes Even Further, Will Buy Risky Debt Too

By:
Chris Gaetano
Published Date:
Apr 9, 2020

The Federal Reserve announced $2.3 trillion worth of new measures to prop up an economy ravaged by the COVID-19 epidemic—including plans to buy junk bonds and collateralized loan obligations—on top of previous emergency actions initiated last month.

The risky debt purchases will happen through the now-expanded primary and secondary market facilities for the direct purchase of corporate bonds, themselves only weeks old. When the facilities first launched, issuers needed to have been rated at least BBB-/Baa3, the lowest possible rating for investment-grade debt, by at least two nationally recognized ratings agencies. Under the new terms of both the primary and secondary market facilities, however, eligible issuers now include those that had been rated BBB-/Baa3 as of March 22, but were subsequently downgraded to BB-/Ba3, which is when debt gets into the speculative-grade, or "junk," category. At this stage, the issuer is considered a significant credit risk and there exists doubt whether it will actually be able to fulfill its bond obligations.

The global pandemic has been creating chaos in the corporate bond market, as companies that had grown accustomed to near-free debt in an ultra-low interest rate environment suddenly began facing tighter credit conditions that they'd never had to deal with before, leading investors to suddenly flee the once burgeoning market. Barron's last month said that corporate debt had seen its worst days since 2008, driven by a mass sell-off of BBB-rated bonds, which make up about half of the corporate bond market.

Setting up the primary and secondary market facilities for corporate debt purchases seemed to calm things down a little bit, as bond sales resumed and sell-offs slowed down. However, this springback was not evenly distributed, as it seemed to help mostly the most safe and credit-worth companies, while riskier companies, which made up between 10 percent and 15 percent of the entire corporate debt market, remained in flux. This proportion has likely grown dramatically, as over the past few weeks credit rating agencies like Moody's and Fitch have been issuing credit downgrades, one after another after another. Overall they have been warning that the long-term outlook for world credit markets remain bleak. A recent report from Moody's said that speculative-grade companies with weak liquidity and refinancing profiles are dominating the recent wave of downgrades, which in turn reflects its predictions that bond defaults are likely to increase significantly.

This is why the Fed has expanded its bond-buying activities to include high-yield junk bonds, though so far only the relatively safe ones (BBB-/Baa3 is the third highest rating that junk bonds can have; there are nine other possible ratings below even that). By extending its debt purchases to these companies, the Fed is trying to stabilize a market sector that it had previously never touched.

The central bank will also be allowing the use of collateralized loan obligations (CLOs) as valid collateral for loans issued under its Term Asset-Backed Securities Loan Facility (TALF), a program which first appeared in the 2008 crisis and has reappeared as part of its new emergency measures.

CLOs are similar to the infamous collateralized mortgage obligations (CMOs) that made headlines during the financial crisis, except they're based on business loan payments rather than mortgage payments. Much as with a CMO, in a CLO, the investor receives scheduled debt payments from the underlying loans, assuming most of the risk in the event that borrowers default (which tends to be more likely than, as these companies are generally riskier than most corporate debt). These CLOs have become major components in how lenders fund credit over the past decade.

When the Fed first announced the revival of the TALF, it excluded these securities from the list of valid collateral to receive a loan. At the time, the only things that counted were securities backed by auto loans, student loans, credit card receivables, equipment loans, floorplan loans, insurance premium finance loans, certain small business loans guaranteed by the Small Business Administration, and eligible servicing advance receivables. The Fed has removed the advance receivables from the list and added leveraged loans (essentially, what CLOs are full of) and commercial mortgages.

However, so far, the Fed will accept only static CLOs rather than managed CLOs as collateral. The difference between the two is that in a static CLO, the collateral or referenced entity is known and fixed through the life of the asset, which lets investors assess tranches with full knowledge of what the collateral will be. In contrast, a managed CLO has someone behind it actively making deals. Further, those who use a CLO as collateral will face the highest interest rates for TALF loans, 150 basis points over the 30-day average secured overnight financing rate.

The borrowing program has now also extended into municipal bonds used by local governments to fund building initiatives such as schools, roads, dams, train stations, and other capital projects. The new facility will directly buy bonds issued by states, counties of more than 2 million residents, and cities of up to 1 million residents. Purchases can be up to an aggregate amount of 20 percent of their general revenue for fiscal year 2017, though state governments can request more purchases in excess of that limit to assist other political subdivisions that are not otherwise eligible for the facility.

The central bank will also provide further financing for loans made through the Paycheck Protection Program (PPP) established by the CARES Act. Essentially, it will extend credit to financial institutions that issue PPP loans to small businesses, using those same loans as collateral. The maturity date will be the same one as the loan used to collateralize the Fed credit. While banks are responsible for administering these loans, the program's implementation has encountered major delays due to not just capital concerns (which the Fed is trying to ally) but the Small Business Administration's antiquated technology and ongoing regulatory ambiguity.

Finally, the Fed has opened what it calls the Main Street New Loan Facility (MSNLF), which is meant to facilitate the creation of new business loans, and the Main Street Expanded Loan Facility (MSELF), which is meant to facilitate extensions of already existing loans. Those participating in one cannot participate in the other. Eligible borrowers under this program are U.S. businesses with up to 10,000 employees or up to $2.5 billion in 2019 annual revenues. Loans under the MSNLF will be a minimum of $1 million and a maximum of $25 million; for the MSELF, that range is between $1 million and $150 million. In either case, the Fed facility will own a 95 percent stake in the loans while the lender keeps a 5 percent stake. The two will share risk on a pari passu, or equal, basis.

Loans made through these facilities cannot be used to pay pre-existing loans from the lender to the borrower. A borrow must refrain from repaying other debts save mandatory principal payments for the term of the loan; must attest that it requires financing due to the COVID-19 pandemic, and that "it will make reasonable efforts to maintain its payroll and retain its employees" during the loan term; meet EBITA leverage requirements; follow all the compensation, stock repurchase and capital distribution restrictions outlined in the CARES Act for recipients of direct loans; and certify that it does not have conflicts of interest that would prohibit from taking part in the facility.

Federal Reserve Chair Jerome Powell noted that these measures are being instituted amid extremely unusual circumstances, and when the crisis is over, he pledged that "we will put the emergency tools away." He also emphasized that the funds allocated for these programs do not mean the Fed is simply giving money to banks, as it expects that these loans will be repaid fully.

"I would stress that these are lending powers, not spending powers," he said. 'The Fed is not authorized to grant money to particular beneficiaries. The Fed can only make secured loans to solvent entities with the expectation that the loans will be fully repaid. In the situation we face today, many borrowers will benefit from these programs, as will the overall economy. But there will also be entities of various kinds that need direct fiscal support rather than a loan they would struggle to repay."

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