Fed to begin buying corporate bonds

The Federal Reserve said Monday that it will begin buying individual corporate bonds under its Secondary Market Corporate Credit Facility, an emergency lending program that to date has purchased only exchange-traded funds.

The central bank also spelled out for the first time how it plans to implement its buying strategy, saying it would follow a diversified market index of U.S. corporate bonds created expressly for the facility. The Fed built the index internally, and a spokesman couldn’t immediately say whether its details would be made public.

“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,” the Fed said in a statement. “This indexing approach will complement the facility’s current purchases of exchange-traded funds.”

The creation of the index removed a potential hurdle for companies that would have had to certify that they were in compliance with restrictions outlined for the program.

INVESTORS CHEER

U.S. stocks climbed to the highs of the day after the announcement. BlackRock’s iShares iBoxx $ Investment Grade Corporate Bond exchange-traded fund, the largest credit ETF, jumped 1.9% to hit session highs, while the iShares iBoxx High Yield Corporate Bond ETF climbed as much as 1.6%.

The cost to protect investment-grade corporate debt against default dropped the most since April 9, when the Fed expanded the scope of its bond-buying program to include some high-yield debt.

“It’s a significant positive,” said Dominique Toublan, head of U.S. credit strategy at BNP Paribas. “The main reason is that they removed the requirement that issuers certify their eligibility. Many investors were worried that this would impair the ability of the Fed to buy bonds.”

The SMCCF is one of nine emergency lending programs announced by the Fed since mid-March aimed at limiting the damage to the U.S. economy by the coronavirus pandemic. With a capacity of $250 billion, it has so far invested about $5.5 billion in ETFs that purchase corporate bonds.

The New York Fed said in a separate statement that purchases of bonds from eligible sellers will begin on Tuesday.

BUYING LEVELS

Market watchers said that while the announcement wasn’t a complete surprise, confirmation by the Fed that it would start buying individual bonds in addition to ETFs provided additional support for the bond market.

The program also laid out what might be a wider pallet of bonds than was originally expected, according to Dennis DeBusschere, head of portfolio strategy at Evercore ISI.

“The reason credit spreads are tight is because investors believe that they would follow through on the program,” DeBusschere said. “If they didn’t follow through, credit spreads would move significantly wider and the Fed would have to purchase even more debt to shore up credibility.”

The Fed said it could slow or even pause daily purchases if market functioning showed sustained improvement, though buying could pick back up if conditions worsened again.

An index assures the Fed complies with the spirit of the law under Section 13.3 of the Federal Reserve Act which says emergency lending facilities must be broad based, and provides a mechanism for the central bank to avoid industry concentration.

Earlier Monday, the Fed separately announced that it has opened its Main Street Lending Program for small and midsize businesses.