In response to the recent COVID-19 outbreak, Congress recently approved a $2 trillion stimulus package in an attempt to offset the potentially disastrous economic effects of COVID-19. Meanwhile, central banks are implementing increasingly drastic measures aimed at preserving the availability of capital during the looming recession, which appears increasingly imminent as the global economy remains in a standstill.
Corporate Debt Balloons to All-Time Highs
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity.” Never has that sentiment from A Tale of Two Cities been truer than today. On the heels of a twelve-year bull market run, party-goers are finally stampeding toward the exits as the world has become engrossed in a global pandemic and people everywhere are being ordered to stay at home. In turn, the pandemic has highlighted the extraordinary debt levels that companies have assumed over the past ten years.
The meteoric rise of private equity has helped fuel the investor stampede toward higher returns. Oftentimes, these private equity firms borrow billions at a time to purchase shares in publicly-traded companies. The domino effect soon becomes clear: If the price of the underlying investments providing the basis for the leveraged loan go down, companies may be unwilling to meet their ongoing debt obligations. The recent plummet in oil prices plunged nearly $110 billion in U.S. energy company bonds into distressed territory. But the risks are not limited to the oil and gas industry.
In July 2019, the Bank of England issued a Financial Stability Report detailing the challenges facing global banking institutions. The report included several examples of the burgeoning global debt load: In China, non-financial sector private debt has surpassed 200% of GDP; the sustainability of Italian government debt remains in question; trade tensions continue to weigh down economic growth; and corporate indebtedness has reached an all-time high. In fact, the report dedicated an entire section to the risks posted by leveraged corporate lending, noting that “[l]everaged loan holdings by open-ended investment funds are significantly higher than pre-crisis, and large-scale redemptions during stress could amplify price falls.”
More recently, the Financial Stability Board (“FSB”) published a report on December 19, 2019, entitled “Vulnerabilities associated with leveraged loans and collateralised loan obligations.” The report cited a rise in non-bank investors—think investment funds, insurance companies, pension funds, broker-dealers, and holding companies—with insurers holding the largest non-bank share of collateralized loan obligations, often with lower-rated tranches of loans. As the report notes, highly leveraged companies are more vulnerable to external shocks, leading to the current panic about the risk associated with holding corporate debt and subsequent sell-off.
The rise of exchange-traded funds (“ETFs”) has only amplified the sell-off in bond markets. For years, ETFs tracking various bond markets provided an easy way for unsophisticated investors to diversify their investments, and in turn, provided additional capital for the bond markets. During the recent COVID-19-induced panic, these ETFs began selling off in droves, further increasing the selling pressure that already existed in bond markets.
Central Banks Throw Debt Markets a Lifeline
In response to the growing liquidity crisis, on March 19, 2020, the European Central Bank announced a support regime called the “Pandemic Emergency Purchase Programme” to purchase at least 750 billion euros worth’ of public and private sector bonds. Although this program will help to ensure liquidity in the bond market, the program notably does not include purchases of bond ETFs. Shortly thereafter, ECB president Christine Lagarde announced on Twitter that “[t]here are no limits to [the ECB’s] commitment to the euro,” apparently indicating that the ECB would not limit its bond purchasers to the initial 750-billion-euro cap. Importantly, the lack of a spending cap on the program could leave it vulnerable to legal challenges moving forward.
The Federal Reserve initially responded to COVID-19 by cutting the federal funds rate to near zero. But that was only the tip of the iceberg. On the same day as the rollout of the ECB program, the Federal Reserve announced new “temporary U.S. dollar liquidity arrangements (swap lines)” with the central banks of nine additional countries in an effort to offset the recent illiquidity in markets worldwide. In addition, the Federal Reserve has announced a veritable alphabet soup of programs to counteract the effects of COVID-19, including:
- Implementing unlimited quantitative easing, consisting of the Fed purchasing roughly $625 billion of bonds a week moving forward. If that trend continues, the Federal Reserve would own two-thirds of the Treasury market a year from now.
- CPFF (Commercial Paper Funding Facility). If this program sounds familiar, it’s because the Fed introduced this program from 2008-2010 in response to the 2008 financial crisis. It is intended to increase the availability of credit during downturns by the Federal Reserve Bank of New York purchasing highly rated unsecured commercial paper directly from issuers.
- PMCCF (Primary Market Corporate Credit Facility). Similar to the CPFF, the PMCCF is intended to ensure liquidity in the markets by purchasing eligible corporate bonds and loans directly from issuers.
- TALF (Term Asset-Backed Securities Loan Facility). TALF allows the Fed to act “as a funding backstop to facilitate the issuance of eligible [asset-backed securities]” beginning on March 23, 2020. The TALF will “initially” allow for up to $100 billion in loans.
- SMCCF (Secondary Market Corporate Credit Facility). Under the SMCCF, the Federal Reserve Bank of New York will purchase eligible individual corporate bonds and corporate bond portfolios.
- MSBLP (Main Street Business Lending Program). The Federal Reserve has only announced that this program will soon exist, with details soon to follow. In essence, the MSBLP will support lending to eligible small-and-medium sized businesses.
Because the Fed is not allowed to purchase or lend against securities without government guarantees (such as Treasury securities or agency mortgage-backed securities), the Fed is funding a special purpose vehicle for each program and the Treasury will make the investments in each program. In turn, BlackRock Inc. has been tapped to purchase the securities and handle the day-to-day operations of the securities on behalf of the Treasury, which will own the underlying securities.
If this sounds legally questionable, that’s because it probably is. These arrangements essentially merge the Fed and the Treasury together as a single entity to avoid limitations on how the Fed can invest in financial markets. In essence, these programs are nationalizing large portions of the financial market, similar to steps taken in 2008 but on a much, much larger scale.
At bottom, these drastic measures vest the executive branch with extraordinary capital-injection powers normally reserved for the Fed, which historically has operated independent of politics. It remains to be seen whether that will continue to be true. In light of the upcoming election, it appears more and more likely that these programs will be implemented aggressively to boost equities—and corporate debt levels—to loftier and loftier levels.