The Federal Reserve has revealed that on Monday (15th June 2020), it will begin buying individual corporate bonds under its secondary market corporate credit facility. This credit facility has only purchased exchange traded funds, therefore to have an emergency lending programme now incorporating corporate bonds is a big stimulus from the FED.
We saw markets react to this news on Friday, with a steep decline in the DXY (falling from 97.00 to below 96.56 , last night). Risk assets also caught a bid, with AUD/USD touching 0.6980 and NZD/USD reaching 0.6500, overnight. EUR/USD advanced to 1.1350 from 1.1280 and GBP/USD reached as high as 1.2687 from around 1.2550, bolstered by USD weakness. It is evident that the market has taken this move by the FED as a big confidence booster, increasing the attraction for holding riskier assets.
The SMCCF is one of nine emergency lending programs announced by the FED since mid-March. These programmes have been aimed at limiting damage to the U.S economy caused by Covid-19. With a total capacity of $250 Billion, it has invested around $5.5 billion in ETFs that purchase corporate bonds.
What is a Corporate Bond?
A corporate bond is essentially a debt instrument, issued by a company to sell to investors through secondary markets. When a company needs to raise funds it can issue shares, sell equity to venture capitalists, consider private equity, or most commonly, issue a bond.
A bond enables investors to lend money directly to a company, in return the company will pay a yearly interest on that bond for a fixed period. This time period is also known as a maturity date, you can have 5-year bonds, 10-year bonds etc. The interest paid can either be fixed or floating (typically fixed). At the end of the maturity, the bond expires and the investor will receive their initial investment back.
Company A issues a 10-year corporate bond, paying a 3% PA. You lend £1000, therefore every year you will receive £30 for 10 years = £300, and after the 10-year period, the bond expires and you will receive your initial £1000 back. As an investor you made a 30% return on the initial investment over a 10-year period.
How will the FED do it?
The FED stated that it would follow a diversified market index of U.S corporate bonds created specifically for the credit facility. This index was built internally by the FED, the context of this index has not yet been made public.
The FED said in a statement ‘This index is made up of all the bonds in the secondary market that have been issued by U.S. companies that satisfy the facility’s minimum rating, maximum maturity and other criteria’.
There have been questions raised about the type of bonds the FED will buy, there is speculation of Junk bond buying, indicated by the FED as ‘high yield debt instruments. These are not backed by any assets and are therefore considered to be high risk, raising eyebrows by market participants.
Powell will be speaking later today and will hopefully address this in more detail.
Why is it good for companies?
Mostly for two main reasons;
1) Companies will be able to receive lending at cheaper rates, as they are buying directly from the US government.
2) Companies that may not have good credit ratings will be able to achieve funding through this programme. This is a huge benefit, as under these conditions, businesses have been massively impacted as a result of less consumer spending, consequently this decreased their credit ratings and makes their respective bonds less attractive.
What does this mean for you ?
As mentioned above, markets have taken this FED initiative as a major confidence booster, this means riskier assets are likely going to remain relatively supported. Therefore risk FX , equities and commodities such as Oil should enjoy further flows. Companies that were not able to receive enough funds from previous government loan programmes, now have a fall back through corporate bonds, which is a huge plus for equities.
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