The Fed’s Rescue of Risk-Takers Creates Dangers for the Future

(Bloomberg Businessweek) -- When the coronavirus pandemic reached America’s shores, bond traders knew exactly what to sell first.

In the span of four and a half weeks, from Feb. 19 to March 23, the gap between rates on U.S. Treasuries and corporate bonds rated double-B, or just below investment-grade, spiked to 8.65 percentage points from 1.9 percentage points—a sign investors were demanding higher premiums to take the extra risk. That kind of punitive interest rate, unseen in more than a decade, froze the market for new debt for all but the bravest borrowers at a critical time.

Double-B credit ratings indicate a good deal of risk, but not necessarily imminent default. This blowup was something more. For veteran bond traders, it wasn’t simply about the current market but the one they feared was around the corner. For years they warned about massive companies all too happy to teeter on the brink of junk, gorging on cheap debt while still clinging to triple-B grades. AT&T, Boeing, and General Electric headlined the more than $3 trillion of corporate securities that were a shock away from losing their investment grades. That seismic shift, it seemed, had arrived.

Then the Federal Reserve unleashed its own shock wave: It would backstop corporate America. What’s more, its $750 billion of corporate bond-buying facilities would effectively ignore credit rating agencies. If a company was investment-grade-worthy before Covid-19, that was enough to secure funding from the U.S. central bank. In one fell swoop, the Fed defused a powder keg. It wasn’t quite another too-big-to-fail moment, but it wasn’t far off. “They had to intervene here—this all just happened so quickly,” says Matt Daly, head of corporate bonds at Conning. “Many of these companies weren’t insolvent, but when push comes to shove, they had to have access to capital.”

Almost instantly, things went back to the way they were. Boeing Co., downgraded and refusing U.S. government assistance, easily borrowed $25 billion on April 30 in the sixth-largest corporate-debt deal ever. It capped a record $300 billion month for the investment-grade market. Federal Reserve Board Chair Jerome Powell chalked this up as a win. “There’s a tremendous amount of financing going on, and that’s a good thing,” he said at a press conference on April 29.

The following day, after persistent lobbying by business groups, the Fed expanded its Main Street Lending Program to bring in more small and midsize enterprises, including those that had used a widely abused accounting technique to adjust results to make earnings appear stronger to secure loan deals. Global regulators had warned about this practice; now the Fed was tacitly endorsing it. It’s harder to spin that as winning.

When this crisis passes, central bankers may go soul-searching about their role in enabling the credit markets to reach this point. Namely, is $74 trillion of global nonfinancial corporate debt sustainable? What can the central bank do during the next expansion to steer executives away from loading up their balance sheets with bonds and loans?

One answer they may consider: Raise interest rates sooner. The Fed left its short-term rate locked near zero for an unprecedented stretch from December 2008 through December 2015. False starts and general unease about upsetting a slow recovery left policymakers inclined to do nothing, even if it might have encouraged excessive borrowing among companies and risk-taking by investors. The Fed feared that if it raised rates the economy would wobble, debt-laden companies would topple, and it would just have to lower rates again.

Although corporate leverage didn’t bring about this economic crisis, the debt overhang could hinder any revival. The question for Fed officials is whether that cost should be an input into future policy decisions. They are guided by a dual mandate of achieving maximum employment and stable inflation, but they’re also charged with maintaining financial stability. If debt markets can’t hold up without the backing of what Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, has called “an infinite amount of cash” at the Fed, that doesn’t feel too secure. “It’s a tall order for them to try to balance meeting employment objectives, inflation objectives, and financial stability—and keep them all in sync,” says Colin Lundgren, global head of fixed income at Columbia Threadneedle Investments.

For central bankers to step back, they may need to see fiscal policy—the things legislators do—playing a stronger role in supporting the economy even after the worst of this crisis subsides. Passing the baton to elected officials would go a long way toward resolving the Fed’s dilemma.

Brian Chappatta is a columnist for Bloomberg Opinion.

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