Necessary Intervention or Excessive Risk?

June 23rd, 2020

Corporate Bond Risk Before and After COVID-19 Amid the Fed's Market Interventions

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See coverage in HuffPost, Forbes, Vox, Reuters Breaking Views, Politico, Yahoo News Australia.

The current COVID-19 pandemic has resulted in unprecedented fiscal and monetary interventions by governments worldwide to prevent economic collapse. The US Congress authorized the Federal Reserve at the end of March 2020 to intervene in the form of primary (direct lending) and secondary market (the corporate bond market) support to a wide range of sectors. This represents a major foray by the Fed into direct support of companies in the real economy (i.e. non-financial entities) and is intended to ensure credit is available during the crisis.

  • This research finds this intervention represents support of parts of the economy which may have been in secular decline prior to the pandemic, most noteably the fossil fuel energy sector. Should this be so, it raises questions of excessive risk taking by the Federal Reserve on behalf of US taxpayers.

  • The research studies historical credit rating movements across the 11 sectors covered by the S&P1500 population of US corporations and found that the fossil fuel value chain "energy" sector stands out for its exceptional and secular decline over 20 and 5-year time spans, including a 5% decline in the credit ratings of energy companies since the COVID-19 crisis began.

  • On May 29th, the Fed disclosed the first $1.3Bn of purchases, from what could potentially be a $250Bn leveraged corporate bond buying program, through a selection of 15 bond ETFs. Just under $100Mn (or 8%) of the $1.3Bn is represented by corporate bonds of energy sector fossil fuel-related companies (including $22 million of non-investment grade or “junk” bonds). Extrapolated over the maximum volume of the Fed's program, this could rise to $19Bn in fossil energy bonds of which $4Bn are likely to be non-investment grade (or junk) based on current ratings of constituent companies in the energy sector.

  • Given the unique pattern of deterioration of the energy sector compared to others over the last two decades this represents the taking on of extraordinary financial risk in that the credit ratings of the underlying companies in the sector may not improve post-crisis. It is likely the Fed should consider patterns of secular decline in credit ratings within sectors of the economy when implementing its bond purchases in earnest. This to avoid taking on excessive and leveraged financial risk for the Fed and US taxpayers.

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