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Calmer corporate bond markets may limit Fed's total purchases

The Federal Reserve's initial purchases of corporate bonds have helped nudge down corporate borrowing costs closer to pre-pandemic levels. If that continues, the Fed may not have to snap up many bonds after all.

The central bank's Secondary Market Corporate Credit Facility has been buying exchange-traded funds containing companies' bonds for weeks, but as of June 16, the purchases have included the underlying bonds themselves.

Analysts expect those purchases of corporate bonds to be limited given the return of relative calm to markets, unless another pullback in sentiment leads to renewed market stress. As of June 17, the facility held roughly $7 billion in ETFs and corporate bonds, according to the central bank's weekly balance sheet release.

"If things improve and spreads … continue to narrow, I don't think the Fed is going to have to buy much," said Jack McIntyre, portfolio manager at Brandywine Global.

That reflects the facility's purpose as a backstop, one that ensures that markets have adequate liquidity and reduces the chance of future dislocations. The Fed is also planning to launch a related Primary Market Corporate Credit Facility soon, where the Fed will be the sole investor or a partial buyer at primary bond issuances rather than purchase bonds on the secondary market. The two facilities combined are authorized to buy up to $750 billion in bonds.

The Fed's promise of a backstop plus its slashing of interest rates has helped fuel record issuance in corporate bond markets. Indicators that measure the spread between the yields on corporate bonds and effectively risk-free Treasury securities have also eased. The U.S. investment-grade corporate bond spread fell to 1.58% the day the Fed started purchasing corporate bonds, down from a peak of 4.01% on March 23.

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The central bank is only planning on buying bonds issued by investment-grade U.S. companies and so-called "fallen angels," those that had met that criteria as of March 22 but were downgraded to high-yield during the pandemic. The Fed's limited ETF purchases have included funds that focus on junk bonds, contributing to narrower spreads in the high-yield sector.

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The Fed's actions have "greatly improved" market conditions, but spreads are unlikely to return to pre-pandemic levels until volatility subsides, BMO Capital Markets strategist Daniel Belton wrote in a research note.

"The reality of economic recession and uncertainty should put a floor on how narrow spreads can trend," Belton wrote.

At a hearing this week, Fed Chairman Jerome Powell said the usage of the facility will depend on market conditions and that it would pick up if credit conditions sour again.

"If market functioning continues to improve, then we're happy to slow or even stop the purchases, and if it goes the other way, then we'll increase [them]," Powell told the Senate Banking Committee on June 16.

Powell: Fed not trying to 'run through the bond market like an elephant'

The Fed's bond purchases has drawn skepticism from Sen. Pat Toomey, R-Pa., who sits on the oversight commission that will review the emergency loan programs from the Fed and Treasury Department.

The commission's latest report, released June 18, asked the two agencies to explain why continued bond purchases are necessary when markets are mostly functioning smoothly. It also told the agencies that they should ensure the purchases do not run "for a longer period of time than is necessary."

Fed purchases at a time when credit conditions have calmed may create the "risk that we diminish price signals" from bond markets that would otherwise flag potential trouble spots, Toomey told Powell at the June 16 hearing.

But Powell said the Fed needed to follow through with its promise to buy bonds, attributing much of the recent improvements to the Fed's announcements that it would wade into the corporate bond market. Fed officials started the individual bond purchases out of "an excess of caution to preserve these gains" in market functioning.

"I don't see us as wanting to run through the bond market like an elephant doing things and snuffing out price signals and things like that," Powell said.

The Fed's follow-through on bond purchases helped ensure it "preserves 100% credibility — its currency to intervene successfully in the next crisis," Bank of America analysts wrote in a research note.

The Fed did announce a shift on June 15 that the analysts said could lead to quicker corporate bond purchases.

The central bank said its facility will buy corporate bonds to create a portfolio "that is based on a broad, diversified market index of U.S. corporate bonds." That means that the Fed is now able to buy bonds from eligible companies without each firm having to explicitly certify to the Fed that they are eligible for the program. That option will still be available if companies choose to use it.

The Fed says the new indexing approach will "complement" its current purchases of ETFs. The central bank will "gradually move away" from buying ETFs and will over time primarily buy bonds instead, Powell told the House Financial Services Committee on June 17.