18 May 2020
This past week has seen the US Federal Reserve (Fed) commence purchases of US corporate bond ETFs. At present there is little visibility around what has been bought or, indeed, what is even on the list of potential purchases. The Fed has been vague, suggesting its Secondary Market Corporate Credit Facility (SMCCF) ‘may purchase US-listed ETFs whose investment objective is to provide broad exposure to the market for US corporate bonds.’ The market notice then goes on to say that the preponderance of holdings will be in investment grade (IG) ETFs with the remainder in high yield.
It is rational to assume that the Fed will follow similar guidelines to those issued for the corporate bond purchases, namely that they will only buy bonds out to 5 years. As a result, we continue to view the short end of the IG credit curve as the sweet spot for investors both because Fed buying provides protection and because duration risk is low.
At the same time, the yield pick-up versus government bonds is meaningful at around 150bp for the Bloomberg Barclays 0-3 Year US Corporate Index. With Fed Chairman Powell suggesting little appetite to take the funds rate negative, it is going to be hard for government bonds to post strongly positive returns; as such, a strategy of harvesting the higher corporate yields makes sense.
Spreading the goodwill
There is also a case for being constructive on IG bonds beyond 5 years, in our opinion. Is The investment case is based on the following points:
- The Fed acknowledges that it is not always possible to follow the same restrictive path as the one for credit. When purchasing ETFs, ‘In some cases, the holdings of ETFs may include underlying bonds that have a remaining maturity longer than 5 years at the time of purchase.’
- A more serious challenge may be finding a sufficient value of short duration ETFs to purchase. The amount of buying could be substantial with the combined size of both the primary and secondary market CCFs up to $750 billion once leverage is accounted for. At the same time the Fed has restricted itself to buying only up to 20% of an ETF’s outstanding shares. The total value of US IG corporate ETFs listed in the US is $153 billion 1, which implies a purchase potential of just over $30 billion, of which an even smaller proportion will be sufficiently maturity-constrained to suit the Fed. So, barring large creations, it is going to be a struggle to focus buying solely on short duration ETFs. With the window for buying only open until 30 September 2020, this may ultimately push the Fed to purchase some of the broader indices.
- Investors displaced from the front end are likely to extend out along the curve. The credit curve is steep relative to the Treasury curve (Figure 1), with the option-adjusted spreads clearly wider at the long end.