ETFs

The Fed Is Buying ETFs. Now What?

The Federal Reserve's plan to hoover up $750 billion in bond funds could have some serious long-term consquences.

It's official. The Federal Reserve is now buying bond exchange-traded funds (ETFs).

Specifically, as part of the stimulus effort to counteract the effects of the coronavirus lockdowns, the Treasury gave the Fed $75 billion, which the Fed will in turn leverage 10-to-1 to buy $750 billion in corporate debt. Some of that figure will be in the form of corporate bond ETFs and even junk bond funds.

In a lot of ways, this is no big deal; it's essentially just the next logical progression of the Fed's traditional open-market operations.

But in a few critical ways, this really is a major policy shift – one that potentially makes a major weakness in the bond ETF space even more dangerous.

Why Is the Fed Buying ETFs?

The Fed has bought and sold trillions of dollars of Treasury and agency debt over the years, yet they've never dabbled in ETFs.

So, why now?

The answer here is pretty simple. The Fed essentially has the same issue that other passive indexers do. They're looking to get exposure to the corporate bond market as a whole, but not necessarily to any single company. The Fed isn't a bond fund manager. Nor does it have the interest or the inclination to research the credit worthiness of individual bond issuers.

Furthermore, there's a political element. The Fed needs to maintain its image of neutrality and can't be seen as favoring individual companies. The last thing Fed Chair Jerome Powell needs is to face a congressional firing squad over his decision to buy – or not buy – the bonds of a controversial or politically incorrect company.

Buying passive bond index ETFs – and having BlackRock (BLK) manage the endeavor – extricates the Fed from that situation.

Why Is This Bad?

The Fed's ostensible reason for buying corporate bonds was to improve liquidity in the bond market. During the March rout, the credit markets seized up. Liquidity disappeared, and bond prices dropped like a rock.

By jumping into corporate bonds, the Fed is looking to keep the market orderly and functioning. That sounds great, but here's the problem: By purchasing the bond ETFs rather than the bonds themselves, the Fed actually makes an existing problem worse.

"Bond ETFs create a false sense of liquidity," says Mario Randholm of Randholm & Co., a money manager with clients in Europe and South America. "The ETFs themselves are extremely liquid and even trade on the NYSE and other major exchanges. But the bonds they own are not. Liquidity in the ETF is not the same thing as (liquidity in the underlying bonds)."

Exchange-traded funds are an attractive vehicle because you can create and destroy shares as demand warrants. When there is more demand for an ETF than current inventory can support, large institutional investors create new shares by buying up the underlying holdings and bundling them into new creation units. When demand for the ETF falls, the institutional investors can break apart shares of the ETFs and sell the underlying holdings.

How is the Fed going to unwind three quarters of a trillion dollars in corporate bonds? How could they unload these bond ETFs without crushing bond prices?

No one knows, and that's exactly the problem. The Fed is about to become the largest lender to corporate America, and unwinding this might be impossible.

What Does This Mean for Stocks?

In the capital markets, a rising tide lifts all boats. By hoovering up hundreds of billions of dollars in bonds, the Fed is essentially freeing up capital that will have nowhere else to go but to the stock market.

This isn't news, of course. The Fed's interventions and the promises of more interventions are the primary reason that the stock market has been on fire since late March.

It remains to be seen how far this trend goes. The Fed's interventions were a major driver of the 2009-20 bull market. Some would argue they were the biggest driver, in fact.

And as a general rule, it's a bad idea to fight the Fed. It has a bigger wallet than you.

Most Popular

Your Guide to Roth Conversions
Special Report
Tax Breaks

Your Guide to Roth Conversions

A Kiplinger Special Report
February 25, 2021
9 Great Growth ETFs for 2022 and Beyond
ETFs

9 Great Growth ETFs for 2022 and Beyond

These growth ETFs offer exposure to higher-risk, higher-reward stocks while lessening the risk of a single stock torpedoing your returns.
January 18, 2022
The 10 Best Closed-End Funds (CEFs) for 2022
CEFs

The 10 Best Closed-End Funds (CEFs) for 2022

These high-yielding CEFs won't just significantly boost your portfolio income. They'll also allow you to buy their underlying stocks and bonds at a di…
January 12, 2022

Recommended

Stock Market Today (1/25/22): Stocks End Down on Another Roller-Coaster Day
Stock Market Today

Stock Market Today (1/25/22): Stocks End Down on Another Roller-Coaster Day

The major indexes stage another comeback Tuesday but this time can't escape declines; Microsoft falls after hours despite an earnings beat.
January 25, 2022
Stock Market Today (1/24/22): Dow Erases 1,100-Point Intraday Drop to End Higher
Stock Market Today

Stock Market Today (1/24/22): Dow Erases 1,100-Point Intraday Drop to End Higher

The S&P 500 was on pace to close in correction territory before reversing higher.
January 24, 2022
Tesla Stock: TSLA Headlines Busiest Week of Earnings So Far
stocks

Tesla Stock: TSLA Headlines Busiest Week of Earnings So Far

Our preview of the upcoming week's earnings reports includes Tesla (TSLA), Apple (AAPL), Microsoft (MSFT), Intel (INTC) and Chevron (CVX).
January 24, 2022
8 Facts You Need to Know About Stock Market Corrections
Markets

8 Facts You Need to Know About Stock Market Corrections

Scary as they are, drawdowns are a normal part of the investing process. Having a financial plan in place and sticking to it is every investor's best …
January 23, 2022