Sunday, April 12, 2020

The Fed Is Killing the Two Main Functions of Wall Street: Price Discovery and Prudent Capital Allocation

On Thursday, knowing that a three-day Easter weekend was coming and the attention of the public would be elsewhere, the Federal Reserve announced that it would allow two of its emergency lending programs to begin buying junk bonds. Those are bonds with less than an investment-grade credit rating, meaning they have a greater likelihood of defaulting. The Fed is not simply accepting junk bonds as collateral for loans, it will actually be buying junk bonds — potentially hundreds of billions of dollars of them. 

Two of the popular junk bond ETFs, iShares iBoxx High Yield Corporate Bond ETF (symbol HYG) and SPDR Bloomberg Barclays High Yield Bond ETF (symbol JNK) closed the trading day on Thursday up 6.55 and 6.71 percent, respectively, on the announcement. Those ETFs had been plunging in price for most of the month of March. 

For years now, prudent investors have been forgoing risky investments like junk bond ETFs and accepting a much tinier yield on U.S. Treasury securities. Now, high rollers like hedge funds that bought junk bonds and junk bond ETFs and received the higher yields, are getting bailed out of these risky bets. The markets will now, going forward, price junk bonds on a closer plane with Treasury securities, assuming the Fed will not let them fail. 

This is effectively killing the pricing mechanism of Wall Street. A U.S. Treasury note has the unconditional guarantee of the U.S. government to make the timely payment of interest every six months and pay the principal at maturity. Junk bonds are backed by nothing more than deeply-indebted corporations, which can, and do, frequently file for bankruptcy protection, making their bonds sometimes sell for pennies on the dollar. But going forward, junk bond ETFs will be priced on the premise that the Fed may ride to the rescue.

Read the rest here.

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