“We see this as fine-tuning by the Fed, but it could be misconstrued by markets as an expansion of existing credit facilities,” warns DBS Macro Strategist Tan Wei Liang. As bond ETFs do not include all the bonds that the Fed needs to support within their inclusion criteria, the Fed wants to create its own representative index to better include these within its portfolio. An additional purchase of individual corporate bonds is required to build the new index.
If anything, it seems that the Fed is keen to restrain credit market volatility, with Powell resolving that the Fed will not “run through the bond market like an elephant”. Committed to secure market functioning, the central bank is aware that excessive moves could distort price signals or fan investor exuberance. Fed bond purchases are therefore calibrated daily on measures of corporate bond market functioning. These include transaction cost estimates, bid-ask spreads, credit curve shape, spread levels and volatility, trading volumes and dealer inventories.
The past four weeks have seen significant credit market volatility, with one week seeing a massive US$33 billion (S$46 million) increase in holdings and others only slight gains of only around US$1 billion. Tan notes that this represents a worrying departure from the steady pace of Fed bond purchases under previous Quantitative Easing (QE) programs.
“Given the Fed’s reaction function, we think the sharp jump in credit volatility last week should have driven a surge in credit purchases again. This, on top of positive sentiment from the Fed finally starting individual bond corporate bond purchases, could be the driver compressing spreads from last week’s elevated levels. With the Fed using its large credit facilities tactically as a backstop, US credit market volatility could be effectively repressed in the interim,” says Tan.
Tan sees premium to Net Asset Value (NAV) for bond ETFs narrowing as a result of this move, as the Fed now has the option of strategically deploying asset purchase to individual bonds when ETF premiums are too high. Bond ETFs are currently trading at premiums in contrast to March, when they were traded on a discount.
The analyst also does not see material changes in policy impacting credit spreads -- Congress funding for the Fed remains constant and credit spreads have already compressed significantly since March, meaning the emphasis will now be on rolling out the Fed’s Primary Market Corporate Credit Facility (PMCCF).
Rising equity prices due to the easing of lockdown measures may serve as a balm for credit, since it creates the possibility of tapping into equity markets for credit -- even for bankrupt firms. Yet, control of bond price volatility via fed purchases may soon prove short-lived. “Volatility in credit spreads could return approaching 30 September, as markets prepare for the stoppage of Fed purchases,” Tan predicts.
