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The Fed’s Intervention Is Widening the Gap Between Market Haves and Have-Nots

In the quest to find markets that look like they will weather an impending economic downturn, many investors are turning to the Federal Reserve.

The central bank, faced with seizing markets during the spread of the new coronavirus, pledged in March to do essentially whatever it takes to restore order in the marketplace. The handful of markets in which it has directly intervened by purchasing assets or lending against them have recouped some of their losses since then, a reassuring sign for investors who were taken aback by the indiscriminate selling that occurred throughout much of March.

But in riskier markets that fall outside of the Fed’s purview — including junk bonds, leveraged loans and nongovernment-backed mortgage bonds — the pain has been slower to abate. Some markets remain essentially closed for business, setting off a race against the clock for borrowers to stay afloat.

The growing disparity is adding to the pressure investors face as they try to identify which investments look like discounted buying opportunities and which look likely to struggle further.

High-yield bonds, for instance, are so beaten down that they might look tempting, said Lauren Goodwin, multiasset portfolio strategist at New York Life Investments. But with the economy in crisis and investors widely expecting a wave of defaults over the coming months, Ms. Goodwin believes investments that have received Fed support are more promising buying opportunities.

Other observers agree. So far, “the markets that the Fed has most directly intervened in have been the ones that are closest to getting back to normal,” said Stephen Stanley, chief economist at Amherst Pierpont.

Corporate bonds are among the biggest beneficiaries of the Fed’s recent programs. Before the central bank’s intervention in March, sales of corporate bonds had come to a virtual standstill, hurt by the tumult rippling across global markets. And investors yanked a record $43.8 billion out of mutual funds and exchange-traded funds tracking high-grade bonds in the U.S. in the week through March 18, according to Bank of America Global Research.

After the Fed said March 23 that it would launch facilities to buy not just Treasurys but also corporate bonds carrying investment-grade ratings, the corporate-debt market showed signs of stabilizing. Companies ranging from Mastercard Inc. to Nike Inc. to Pfizer Inc. were able to issue bonds at lower yields than their initial guidance, a sign that investor appetite for the debt had improved. Over the following two weeks, companies issued a record $177 billion of investment-grade bonds, according to Dealogic.

In contrast, companies with riskier junk-rated debt have completed just a handful of deals since March 23. And one large exchange-traded fund tracking the high-yield bond market, the iShares iBoxx High Yield Corporate Bond Fund, in the first quarter slumped to post its worst quarterly performance since 2008. Though it has rebounded slightly in recent days, the average cost over Treasurys for companies with junk-rated debt to borrow is near its highest since the financial crisis of 2008.

“It’s very difficult for the Fed to help high-yield [bonds] because the Fed is not supposed to take credit risk,” said Hans Mikkelsen, head of U.S. high-grade credit strategy at Bank of America. Mr. Mikkelsen’s team has been recommending investors purchase what the Fed buys in the short term, reasoning that debt issued by companies that have access to the Fed’s credit facilities will bounce back before debt issued by lower-rated companies.

Leveraged loans, a cousin of junk bonds that have been among the most popular investments in recent years, also have struggled. Individual investors and hedge funds alike have dumped the debt in recent weeks in anticipation of a surge of corporate defaults.

To some extent, such divides are expected, analysts say. And in time, the Fed’s support for safe markets could flow through to riskier ones. During the last financial crisis, the Fed bought up Treasurys and safe mortgage-backed securities, eventually helping private investors to become more comfortable lending to riskier borrowers such as junk-rated companies.

But since the last crisis, the financial ecosystem has changed. More lending is done by nonbank entities that don’t have a financial cushion to keep lending when markets turn stormy and investors seek shelter. At the same time, many companies, individuals and governments have become more reliant on functioning debt markets to remain solvent.

“If it gets much worse for the U.S. economy and markets, then some of these programs are going to be used for all kinds of asset classes,” Mr. Mikkelsen said.

Some industry trade groups, watching the divide between markets, are already pushing to get the Fed to buy more types of assets. One place this is happening is in the mortgage market, where a gap is forming between mortgage bonds backed by the government and those that aren’t.

The Fed has begun buying a massive stockpile of the former, propelling a rebound in that market. But it hasn’t intervened in the latter market, leaving it effectively closed for business. Lenders that specialize in nongovernment-backed mortgages, many of which are independent nonbank companies, are now pausing operations and laying off staff, limiting the availability of these mortgages to some home buyers and owners.

Some real-estate investment trusts with big portfolios of nongovernment-backed mortgage bonds have been particularly hard hit, forcing them to sell into a down market. New Residential Investment Corp. said last week that it sold $6.1 billion worth of these mortgage bonds. Two Harbors Investment Corp., another REIT, said in March that it also sold its entire portfolio of these mortgages. Many REITs have struggled to meet requirements from their banks to post more collateral against their loans.

The Structured Finance Association, a trade group, asked the Fed in March to increase its asset-backed-lending facility to support these nonagency mortgages and other types of asset-backed bonds.

Another part of the mortgage market that has struggled without Fed support is a niche type of securities issued by government mortgage corporations Fannie Mae and Freddie Mac. Since 2013, the two firms have packed up the credit risk tied to mortgages they back and sold it to investors as bonds. Since the market turmoil began, the premium that investors demand to own those bonds spiked in recent weeks and has shown little sign of reversing, according to data from MSCI Inc.

“It’s tough for the Fed to basically buy the whole financial system,” said Roberto Perli, a former Fed economist and head of global policy research at Cornerstone Macro. “They have to prioritize and say, ‘Hey, what is the most urgent need?’ They’ll go down the spectrum only if needed.”
Source: Dow Jones

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