Buying What the Fed Buys

Companies receiving central bank aid are more likely to make quick comebacks Continue reading... Read More...

On Monday, March 23, the Federal Reserve announced a series of aggressive stimulus measures to combat the negative effects of the Covid-19 pandemic on the U.S. economy.

“Aggressive effort must be taken across the public and private sectors to limit the losses to jobs and income and to promote a swift recovery once the disruptions abate,” the Fed said in a press release. The stimulus measures include the following:

Unlimited purchasing of Treasury securities and mortgage-backed securities.
Lending up to $300 billion to employers, consumers and businesses.
Establishing additional credit facilities to lend to large employers.
Increasing the flow of credit to municipalities.
Establishing a facility to lend to certain small and medium-sized businesses.
Purchasing investment-grade corporate bonds.

Businesses that receive Fed support through any of the above measures are likely to recover more quickly from the economic crisis. This is especially true now that the central bank is purchasing corporate debt, which will make things easier for specific companies more than the economy at large.

When there is a large uptick in demand for a company’s assets, share prices will typically rise. Thus, regardless of whether U.S. stocks have hit the bottom or whether they still have room to fall before recovering, investors may want to consider buying what the Fed is buying when it comes to debt and equity markets.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Corporate debt” data-reactid=”30″>Corporate debt

When purchasing corporate debt, the Fed is not likely to pick and choose which debt it buys based on a company’s long-term stock price prospects, as doing so would serve to unbalance the economy more than help it.

Instead, the central bank has pledged to purchase up to 20% of the assets of U.S.-listed bond exchange-traded funds, which provide broad, passive exposure to investment-grade bonds. ETFs also have the advantage of being more liquid than bonds, which is an essential quality when the goal is to stimulate markets as quickly as possible.

In general, securities listed on ETFs tend to trade at higher prices relative to intrinsic value than their non-ETF counterparts. For example, Microsoft (NASDAQ:MSFT), Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN), Alphabet (NASDAQ:GOOGL) and Facebook (NASDAQ:FB), the companies whose common stock together makes up approximately 18% of the S&P 500 Index, all have trailing 12-month price-earnings ratios above 20 as of March 30. Of the five, only Apple has a current price-earnings ratio below 20 at 19.98.

With the central bank potentially boosting the demand for bond ETFs by up to 20%, any of these ETFs that it purchases will most likely see a corresponding increase in value. In light of this, which bond ETFs is the Fed most likely to purchase?

One likely candidate is the iShares iBoxx $ Investment Grade Corporate Bond (LQD) ETF, which purchases investment-grade corporate bonds that have a weighted average maturity of around 13 years. With a market cap of $38.08 billion and a dividend yield of 3.39%, the LQD ETF is up 3% over the past year and down approximately 6% since U.S. markets peaked in mid-February.

The iShares ETFs are run by BlackRock, the world’s largest money manager, which has agreed to cooperate with the New York Fed by not charging it fees on its ETFs. There are also plans for BlackRock to lead two corporate credit facilities for the Fed, one for existing bonds and one for new bonds.

The iShares 1-3 Year Credit Bond ETF (NASDAQ:IGSB) is another BlackRock ETF for investment-grade corporate bonds, focusing on shorter-term debt with an average remaining maturity of one to three years. It has a market cap of $12.63 billion and a dividend yield of 3.13%. The ETF is up 1% over the past year and down 3% since mid-February.

Other investment-grade corporate bond ETFs include the Vanguard Intermediate-Term Corporate Bond ETF (NASDAQ:VCIT) ETF, the Vanguard Short-Term Corporate Bond ETF (NASDAQ:VCSH) ETF and the SPDR Portfolio Intermediate Term Corporate Bond (SPIB) ETF.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Top of the ETFs” data-reactid=”80″>Top of the ETFs

In terms of specific companies, the ones that will benefit the most from these bond ETF purchases are the ones that are present in these ETFs. Naturally, companies without investment-grade debt will not benefit from this form of monetary stimulus.

The largest company holdings of the iShares iBoxx $ Investment Grade Corporate Bond ETF and several similar ETFs are the big six U.S. banks – JPMorgan Chase & Co. (JPM), Bank of America Corp. (BAC), Wells Fargo & Co. (WFC), Citigroup (C) and Goldman Sachs Group Inc. (GS). While the current target interest rate of 0% to 0.25% does not bode well for the short-term profitability of banks, the banking industry will likely see gains again if the Fed eventually raises interest rates.

Other top investment-grade corporate bond ETF holdings include Apple, Microsoft, AT&T (T) and Verizon (VZ). These giants are on the forefront of tech and communications infrastructure, and their common stocks are also common ETF holdings.

Non-cyclical consumer companies also take up a significant portion of these ETFs. For example, three of the top 10 bonds of the iShares iBoxx $ Investment Grade Corporate Bond ETF are for CVS Health Corp. (CVS). AbbVie Inc. (ABBV) bonds hold a top 10 spot in several of this type of ETF, including the Vanguard Intermediate-Term Corporate Bond ETF.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Venturing into stocks” data-reactid=”85″>Venturing into stocks

Some analysts speculate that in addition to corporate debt ETFs, the Fed will follow the Bank of Japan’s lead and enter the stock market by purchasing shares of common stock, most likely through ETFs as well.

A “whatever it takes” attitude could possibly lead to this, if existing stimulus measures are not enough. After all, with interest rates at zero, the Fed’s most powerful economic stimulus tool has already been exhausted.

On the March 6 meeting of the Shadow Open Market Committee, a board of economists that watches over Fed activities, Boston Fed President Eric Rosengren said, “We should allow the central bank to purchase a broader range of securities or assets.”

Keep in mind that this possibility is completely speculative as of the writing of this article. Before the Fed could buy stocks, it would need to get congressional approval. However, with the Fed unleashing unprecedented stimulus measures, some analysts speculate that it will become even more aggressive in its policies if markets continue to worsen.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Conclusion” data-reactid=”90″>Conclusion

With the Fed becoming active in the economy at unprecedented levels, investors may need to give the institution some weight in their considerations of the companies that will be affected by its decisions.

Long story short, the Fed becoming involved enough in corporate debt to buy up to 20% of investment-grade corporate debt ETFs means that investment-grade companies will be getting a leg up over those with lower credit ratings. This comes at a time when increasing corporate debt in the U.S. has led to waves of credit downgrades, meaning that debt is becoming more concentrated at the top.

Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful research and/or consult registered investment advisors before taking action in the stock market.