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Buying Corporate Debt

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Buying Corporate Debt

In order to keep employers afloat, the Fed announces an extraordinary measure. March 24, 2020
Covid-19
Economy, finance, and budgets

In these extraordinary times, the Federal Reserve has just announced an extraordinary plan: to buy long-term, investment-grade corporate bonds. The European Central Bank proposes to do the same. The idea of any central bank purchasing the debt of individual private companies was unimaginable a few weeks ago but may soon become necessary, being preferable to direct corporate bailouts or bankruptcies.

The corporate debt market consists of the bonds of the private sector. Each company gets a credit rating that determines how much interest it must pay on its loans. AAA-rated firms are the safest and pay lower rates; anything BBB-rated (or BAA, depending on the rating agency) or above is considered investment grade. Anything lower than that is considered “junk” and pays higher yields on its debt, commensurate with the higher risk of default associated with its enterprise.

Both the IMF and the New York Fed issued stern warnings about the corporate bond market over the last few years. Most of the media attention has been focused on the leveraged loan market, where low-grade firms took on lots of debt. Morgan Stanley’s Ruchir Sharma argues that many of these firms should be out of business; they have survived, he says, only because of a cheap credit environment. Now that yields are higher, and credit more expensive, many may indeed fail.

But the bigger worry is what’s happening in the investment-grade market. Since 2012, many firms issued more debt and thus received lower credit ratings. Only two firms, Johnson & Johnson and Microsoft, maintain a AAA rating. The lowest investment-grade category—BBB or BAA—has seen an extraordinary expansion. Firms in this category are now valued at more than $3 trillion—larger than the entire junk market, and now comprising more than half of the entire investment-grade market.

This segment of the market poses many unique risks at a time of extreme financial stress. BBB firms are at risk of seeing their credit ratings downgraded. A downgrade turns them to junk, which means that the cost of borrowing immediately increases; the spread between junk bonds and the lowest-quality investment-grade bonds last week was nearly 5.5 percentage points, at a time when many companies need to borrow to avoid going out of business and keep making payments on existing debt. To make matters worse, many of the owners of BBB/BAA debt are pension funds and insurance companies, which, as fiduciaries, are required to own only investment-grade corporate debt. A downgrade forces them to sell and puts even more pressure on the debt market.

The growth in low-quality investment-grade debt was driven, the IMF argues, by easy credit and low interest rates, which encouraged firms to borrow more. Investors were hungry for these bonds because institutions such as pension funds and endowments needed higher-yield assets to meet their targeted returns; less risky assets have low yields. The lowest category of investment-grade debt was exactly what they needed—until now.

Some blame the current crisis on the Fed because it kept rates low after the 2008 financial crisis. This is not entirely fair. The Fed can only directly influence short-term interest rates, though it can affect longer-term rates to some degree because those reflect the market’s expectations of future rate hikes. But rates on longer-term securities have been low, largely because regulations encourage financial firms to buy lots of debt, and foreign buyers made up a large market.

The Fed will buy corporate bonds—though only investment-grade debt—to provide financial stability. Firms need to borrow now and into the recovery. Without intervention, massive downgrades in the corporate debt market will cause major dislocations, and the market could seize, which means no firms get capital. The most successful part of the Fed’s controversial “quantitative-easing” program was when the central bank bought mortgage-backed securities after that market had frozen. That experience bodes well for the new proposal to buy investment-grade corporate bonds. 

The danger, long-term, is public backlash. Some firms issued debt to buy back equity shares over the last ten years. From a corporate-finance perspective, that may have made sense at the time, but it exposed these companies to more risk. If the Fed buys lots of corporate debt, it could be interpreted as a bailout for that risky behavior. If the corporate-debt market continues to function, however, it will keep people employed. It’s also preferable to government-directed corporate bailouts, because big firms still get their capital from markets and pay a market rate of interest—albeit at a rate supported by intervention from the Fed.

Photo by Mark Makela/Getty Images

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