Fed Starts Buying Individual Corporate Bonds: An ETF Update

The US Federal Reserve recently announced it would purchase individual corporate credit bonds.

    David Mann

    David Mann Head of Capital Markets, Global Exchange-Traded Funds (ETFs), Franklin Templeton

    The US Federal Reserve (Fed) recently announced it would purchase individual corporate credit bonds. David Mann, our Head of Capital Markets, Global ETFs, makes a case for using smaller ETFs to accomplish that goal.

    Last week, the Federal Reserve Bank of New York announced it would start purchasing individual corporate credit bonds on June 16 within the Secondary Market Corporate Credit Facility (SMCCF). This is the same Facility in which it has already been purchasing ETFs since May 12. As my loyal readers can attest, the Fed and ETFs have certainly been hot topics in this forum.

    Given that this is an ETF blog, I am not going to dive too far into the weeds of how the Fed is constructing its broad portfolio of US corporate bonds within the Facility. However, I did want to repeat a point I made in our very first commentary about the Fed buying ETFs.

    The Facility should want low ratios (ratio of exchange volume to primary market volume) as those ETF trades would lead to actual buying of the underlying bonds. Our recommendation would be to focus on low-ratio ETFs (for example, under 3:1 over the past 12 months) as we want that primary market activity. Purchasing high-ratio ETFs may not even lead to any buying of the underlying bonds, depending on what is happening in the market that day.

    The Fed has already bought ETFs and has now moved onto the next phase of owning individual bonds. What if the Fed not only has its cake, but gets to eat it too? By investing in smaller fixed income corporate bond ETFs with lower average volumes, almost every dollar invested in those ETFs would be a dollar invested in the underlying bond markets.

    Put another way, the motivation for using ETFs within the Facility would now be slightly different. The purchases we have seen thus far into the largest ETFs allowed broad exposure to the corporate bond market, but they did not necessarily lead to individual bond buying because of all that on-exchange volume. Now, these smaller ETFs could be used as an explicit conduit for buying individual bonds which is consistent with the aim of the SMCCF.

    Such actions would help the current diversification issues within the SMCCF where 98% of the assets held are with the three largest ETF issuers. More broadly, having more funds over a certain assets under management (AUM) within a given asset class gives investors more choices if those investors have specific AUM or percent ownership limits.

    Additionally, since these smaller active and passive funds are completely transparent, the Fed will have complete clarity on the underlying bonds it owns via the ETF and can adjust its ETF purchases accordingly.

    Lastly, depending on the amount of bond the central bank wants to own, the Fed could revisit the 20% AUM limit, as that percentage is not reflective of the liquidity of either the ETF or the underlying bonds it holds.

    For example, looking at the investment grade space through June 17 via Bloomberg, we estimate there are currently almost $200 billion of eligible ETF assets with approximately $50 billion of those having a secondary/primary ratio under 3:1. That means the Fed could own $10 billion of ETFs from 12 different ETF issuers, while still staying under the 20% hurdle.

    Let’s eat cake!

    What Are the Risks?

    All investments involve risks, including possible loss of principal. Generally, those offering potential for higher returns are accompanied by a higher degree of risk. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. For actively managed ETFs, there is no guarantee that the manager’s investment decisions will produce the desired results.

    ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.