Moral hazard risks are hardly confined to the universe of Wall Street creditors.
At a time like this, when trillions of dollars of taxpayer money are being pumped into the economy and financial rules are being rewritten to provide additional relief, these risks pop up everywhere -- from the bankers and private-equity executives who loaded their companies up with too much debt to homeowners who took on bigger mortgages than they could afford and even to, according to President Donald Trump and his allies, some states that ran big budget deficits and are now seeking federal aid.
The Fed program, for its part, was designed to be targeted in its scope. The central bank said it would buy junk debt only of some companies that recently lost their investment-grade status. Its purchases of collateralized loan obligations, which are in turn the biggest buyers of leveraged loans, will be limited to a small set of the securities.
And even the loans that the central bank will help originate directly have restrictions on leverage that will likely leave out many private-equity owned companies.
Yet what’s transpired since the expanded plan was announced on April 9 is that none of the fine print really matters, at least not now. Markets are rallying even though the Fed has yet to formally set up the facilities through which it will make the purchases or extend new loans. There is also confusion as to which companies would even qualify.
“The signaling effect of what the Fed is doing is powerful,” said Jack Janasiewicz, a portfolio manager at Natixis Advisors. “It was enough to shift sentiment, and when we start to feel better about things, we start buying. Worst-case scenario, if things really fall apart, the Fed will step in.”
Junk Revival
Junk bonds have already recovered roughly half of the losses they suffered during the recent sell-off, while the leveraged loan market is also on the mend. Speculative-grade bond issuers have sold more than $34 billion of debt so far in April, one of the busiest months in recent years.
Companies whose business have been ravaged by social-distancing measures adopted to contain the spread of the coronavirus such as SeaWorld Entertainment Inc., AMC Entertainment Holdings Inc. and Gap Inc. have all successfully tapped bond investors to boost liquidity.
As a result, default rates may not rise as much as initially expected, according to analysts from JPMorgan Chase & Co. and Morgan Stanley.
Some bankers who arrange debt deals for junk-rated companies and their private equity owners are encouraging even riskier borrowers to access the market while the times are good. That would allow buyout firms to sidestep more difficult bank financings or more expensive equity capital injections, which many see as anathema.
Surgery Partners got enough interest from leveraged loan buyers for 10 times the amount it was seeking to borrow earlier this month. While it still paid a punitive yield of over 9%, that was well below the more than 12% it had initially marketed.
A representative for both the company and majority owner Bain Capital declined to comment.
Everyone Wins?
The Fed’s decision to wade into certain high-yield, high risk junk-bond ETFs is one of the more controversial steps taken by Chairman Jerome Powell. Depending on the securities it buys, the move could expose the central bank not just to high quality speculative-grade issuers, but also to corporations on the cusp of bankruptcy.