Advertisement
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.

Advertisement - Article continues below

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.

Advertisement
Advertisement - Article continues below

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.

Advertisement - Article continues below

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)."

Advertisement - Article continues below

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.

Advertisement
Advertisement

Most Popular

What Trump's Payroll Tax Cut Will Mean for You
Tax Breaks

What Trump's Payroll Tax Cut Will Mean for You

President Trump has issued an executive order to suspend the collection of payroll taxes. How much will it save you?
August 9, 2020
What a Payroll Tax Cut Would Mean for You
Tax Breaks

What a Payroll Tax Cut Would Mean for You

If Congress can't pass another stimulus bill, President Trump says he will initiate a payroll tax cut by executive order. How much would that save you…
August 8, 2020
7 Surprisingly Valuable Assets for a Happy Retirement
happy retirement

7 Surprisingly Valuable Assets for a Happy Retirement

If you want a long and fulfilling retirement, you need more than money. Here are the most valuable retirement assets to have (besides money), and how …
August 3, 2020

Recommended

Bonds: 10 Things You Need to Know
Investing for Income

Bonds: 10 Things You Need to Know

Bonds can be more complex than stocks, but it's not hard to become a knowledgeable fixed-income investor.
July 22, 2020
Kiplinger's Weekly Earnings Calendar
stocks

Kiplinger's Weekly Earnings Calendar

Check out our earnings calendar for the upcoming week, as well as our previews of the more noteworthy reports.
August 9, 2020
Stock Market Today 8/7/20: Strong July Jobs Report Has a Dark Side
Markets

Stock Market Today 8/7/20: Strong July Jobs Report Has a Dark Side

A better-than-expected employment report that saw 1.8 million U.S. jobs added in July didn't give the markets much of a boost Friday.
August 7, 2020
The Pros' Top 5 Industrial Stocks
investing

The Pros' Top 5 Industrial Stocks

The industrial sector is lagging badly this year, but anytime there's carnage, there is also opportunity, analysts say.
August 7, 2020