Understanding the Fed’s Bond ETF Program

Yesterday, the Federal Reserve did something it’s never done before: purchasing exchange traded funds (ETFs) that are invested in corporate bonds. As a brand new program, this has generated a lot of confusion on behalf of the public. Why is the Fed buying bonds? Who is the Fed helping by buying corporate bond ETFs?

I’ll try to answer these questions (and more) in this article.

Let’s start with some basics.

A bond is a debt contract: the issuer wants a cash loan, and needs to find someone on the other side to give him one.

Issuers try to entice lenders by offering interest. The higher the interest rate, the more desperate the issuer is to find someone to lend them the cash. The interest rate being offered is called the yield or the coupon. Unlike a typical consumer loan, like a mortgage, bonds are interest-only payments until they “mature”, at which point they have to pay back the entire principal at once.

(As an aside, the reason it’s called a coupon is pretty interesting: in the old days, bonds were literally a piece of paper. But if you hold just a piece of paper, how do you determine how much money you’re owed? One approach was obviously just writing everything down, but that could be cumbersome and liable for error. An innovation was that the piece of paper came with little sections you could cut out to prove you’ve gotten your due. Many decades later, advertisers got the idea to use the same concept in newspapers, to offer discounts to shoppers.)

Bonds are not the only way of raising cash

Of course, issuing bonds is just one way that a firm can raise cash. Firms can also get loans through a traditional bank, or by issuing stock. In recent years, however, issuing bonds has become extremely trendy. In fact, before the covid selloff the size of the US bond market today was about 50% bigger than the size of the stock market.

Why would a firm issue bonds instead of equity? There are many reasons, but the most important has to do with the interest rate. When interest rates are low, especially when they are below inflation rates, then firms are in effect being paid to borrow money. And since the dot-com crash of 2001, the Federal reserve has helped push (especially short-term) interest rates to very, very low levels. So it should be no surprise that many corporations took advantage of this situation and issued lots of short term debt, which was often then paid off by issuing even more short-term debt.

One quirk about the corporate bond market

Bonds do not trade openly on an exchange (unlike stocks or commodity futures). The prices are negotiated basically privately in very illiquid markets. How do bonds get in the hands of investors? Unlike government bonds, which are sold at an auction, corporate bonds are sold by an intermediary like an investment bank — which would do an exhaustive evaluation including doing due diligence, filing legal paperwork, etc. — who would then look to find others in their network to buy the debt. As this is the first way that debt enters the market, we call this the primary market.

After the debt has been issued, the people and institutions who were privileged enough to have an opportunity to buy the bond from directly the dealer have the opportunity to sell. However, unlike stocks, which sell on highly-organized and highly liquid exchanges, the so-called secondary market for bonds is more idiosyncratic. Without a formal exchange platform, the pricing process happens behind closed doors: while the final transacted price is publicly posted, the various bids and offers for the bond are forever shrouded in mystery.

ETF basics

This changed with the advent of ETFs. An ETF works like this: some smartypants (called the issuer) comes up with a crudely conceived idea that there are individuals out there who want to invest in some broad notion, like “short term, high yield, US corporate bonds.” However, these individuals are not rich or privy enough to those special opportunities where bonds are typically bought and sold.

ETFs Are Based on a Notion…

So to implement this notion, and service these potential customers, the issuer first comes up with a precisely determined “basket” of assets that will reflect this idea. This asset basket could be anything: it could be shares in specific companies, it could be commodities, it could be bonds of different maturity or grade, or some zany combination of any of the above.

After the plan for the asset basket has been finalized, some other party — a large institution with deep pockets called an “Authorized Participant” (AP) — will then buy large quantities of those exact assets in the basket. The AP will then hand over those assets to the issuer. The issuer will then issue an arbitrary number of shares to the AP, who can then price them at some fraction of the value of the basket.

A quick example

Let’s clarify this with an example. Smartypants Steve thinks that a lot of people want to track short term, high yield, US corporate bonds. Steve then convinces BMO, RBC, and BNS to join him as APs, who go out and buy a combined $1 billion worth of short term, high yield, US corporate bonds, and hand them over to Steve.

In exchange, Steve issues a billion shares to that basket to the APs. The APs then sells those shares on a market exchange, at $1 each. This is called share creation. Thus, Steve and the APs have combined to create a fund that is traded on an exchange. Hence, exchange traded fund.

How ETFs track and affect the prices of the underlying assets: it’s all about arbitrage

How can you ensure that the ETF will actually track the notion that it’s supposed to be tracking? The short answer is arbitrage. Recall that the APs are the only parties authorized to transact with the issuer. They utilize this privilege to go into the market and buy or sell the ETFs, as well as the asset basket, in order to keep the price on track.

Here’s a simplified example. Say the price of the ETF is higher than the value of the asset basket. To fix this, the APs start by buying the cheap asset basket and exchanging it with the issuer to create more shares. This process bids up the value of the basket. They then sell these newly created shares into the market, simultaneously bringing the price of the shares down while also earning a profit.

What if the price of the ETF is below the value of the asset basket? Now the APs buy the cheap shares, and exchange those with the issuer for assets in the basket. The APs then sell the basket assets into the market. Buying the ETF brings the price up, selling the basket assets brings their prices down, and this process continues until they become equal. Meanwhile, the APs make a profit for their efforts.

Thus, buying or selling ETFs affects bond prices in an indirect way. Specifically, as the price of the ETF deviates from the price of the underlying bonds, this creates an arbitrage opportunity for the AP to intervene and bring the two sets of prices closer together.

The Fed’s Actions: Befitting a Bond Hero, or Bond Villain?

For the last year, the bond markets have been having a lot of trouble. Despite more than a decade of interest rates below inflation, financial markets were in trouble again in the summer and autumn of 2019. The Fed responded by cutting interest rates again, and buying hundreds of billions of dollars worth of other assets.

Even though some were calling for the Fed to start rolling back this policy in January, this clearly did not happen. Back in March during the major COVID–19 sell-offs, basically everyone wanted to sell their bonds and no one wanted to buy. The Fed announced it would help support the market by buying corporate bonds (also known as “commercial paper”) soon. Not only will they buy ETFs in the so-called “primary market”, which is where the wheeling-and-dealing takes place with the direct

Fast-forward to last Monday, when the New York Fed announced that they will begin “certain secondary market corporate credit facility purchases.” In other words, they are starting to buy ETFs. By buying ETFs, the Fed will increase the price of ETFs relative to their underlying bonds. This will create an incentive for the APs to buy more of those bonds in order to sell more shares. This is a roundabout way of increasing bond prices, without having to deal with the complexities of the primary market.

Who benefits?

With the Fed buying bonds in both the primary and secondary market, the primary beneficiaries will be corporate debtors. Especially those corporate debtors who have lost significant cash flows, and as such as struggling to pay their obligations, and engage in more debt financing. This program from the Fed will help them do both.

Secondly, the Fed branch typically responsible for carrying out so-called open market operations will not be conducting these open market operation. That privilege (along with the associated fees) goes to Blackrock, the world’s largest corporate ETF seller.

Moreover, these purchases will be financed via a 10-to-1 leveraged loan from the Treasury Department, as part of the CARES Act. The leveraging is made possible through a process called fractional reserve banking. That is, the Fed is essentially creating hundreds of billions of dollars out of thin air.

The individuals and corporations — the bond brokers, the ETF holders, the APs, etc. — who the Fed buys from using this newly printed money will see their purchasing power increase faster relative to the rest of society. They can then use this new money to buy more financial instruments, bidding those prices up ahead of everyone else.

Finally, even those who never got close to the corporate bond market can still benefit from this action. After all, the Fed announced this program with some detail (including which specific ETFs it is going to buy) in advance. This creates motive and opportunity for savvy market players to buy those ETFs in advance of the Fed, in order to sell it to them at inflated prices. This is a process known as “front running”, and it has already happened to the tune of $1 billion dollars.

Are the Fed’s actions necessary?

Part of the Fed’s strategy is to save so-called “fallen angel” bonds. These are bonds issued by once highly reputable businesses, who have since fallen on hard times and are deemed to be unlikely to pay their debts. The Fed believes that we are in a ephemeral stage of transition, and that these angels will fly again soon… with just a little leg up. They hope to provide that leg up by buying their bonds.

Others disagree with this view. Some believe that these businesses (and their lenders) knowing took a risk when it came to issuing debts, relative to other businesses that played it safe. So bankruptcy for these unwise businesses is an economically efficient outcome.

Summary

To answer the questions from the top: the Fed is buying corporate bonds because that market has been collapsing, putting a lot companies at risk of default and bankruptcy. The Fed is buying these bonds both through the primary markets as well as ETFs; the primary bond markets are opaque, slow, and illiquid, while ETFs (as indirect means of buying bonds through APs) solve these problems.

This qualifies as a bailout for a host of people: (i) bond issuers because as the demand for an ETF goes up, the institution issuing that ETF has to go and buy more of the underlying assets; (ii) bond traders who got caught holding the bag when prices collapsed; and (iii) the bond brokers who get to participate in these exchanges.

As a side effect, when the Fed announces that it’s going to buy bond ETFs, it is enabling front-running. Individuals who were never involved in the bond markets have the incentive to buy those ETFs ahead of the Fed, just to sell it back to the Fed later (at higher prices).

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