In: Finance
What is the High Yield Corporate Bond market Who participates in it? What specific policy measures has the Federal Reserve taken as a result of the Corona Virus epidemic that affect their market? Why?
High-yield corporate bond
A high yield corporate bond is a type of corporate bond that offers a higher rate of interest because of its higher risk of default. When companies with a greater estimated default risk issue bonds, they may be unable to obtain an investment-grade bond credit rating. As a result, they typically issue bonds with higher interest rates in order to entice investors and compensate them for this higher risk.
High-yield bond issuers may be companies characterized as highly
leveraged or those experiencing financial difficulties. smaller or
emerging companies may also have to issue high-yield bonds to
offset unproven operating
histories or because their financial plans may be considered
speculative or risky.
Investors that participate in high yield bonds are-
A variety of investors participate in the high-yield bond market. They include individuals who invest in high-yield bonds through direct ownership and/or through mutual funds; insurance companies; pension funds and other institutions.
Individual investors purchase individual high-yield bonds, often as part of a well-diversified investment portfolio. They also participate in this market through high-yield bond mutual funds.
Mutual funds pool the assets of investors to create portfolios of high-yield bonds. Three separate categories of mutual funds invest in high-yield bonds:
Insurance companies invest their own capital in high-yield bonds. They also participate in the market through “separate accounts” offered in variable insurance and annuity products.
Pension funds invest in high-yield bonds to earn higher rates of return than those available from investment-grade bonds, or as an alternative to investing in an issuer’s stock. Pension fund trustees are fiduciaries that must invest within “prudent man” guidelines and other considerations, which vary from state to state. Recently, in some cases, these guidelines have allowed increased pension fund participation in high-yield bonds.
Collateralized bond obligations (CBOs) are debt instruments that offer many benefits of investment-grade bonds, including current income and a high quality rating. The collateral behind these bonds often consists of a pool of high-yield bonds diversified by issuers and industries, which enables the pool to obtain a higher rating than any individual bond in the pool. CBOs may include several “tiers,” which offer different maturities, or levels of risk.
The Fed has set three primary goals to fight against corona pandemic
First, to support the markets that allow banks to function. The banking system would not work without these short-term funding markets, as banks rely on them, in addition to their deposit base, to make loans. These markets are thus critical to making sure that the financial system doesn’t amplify the enormous shock from the coronavirus.
Second, to make sure the market for U.S. Treasury bonds is working smoothly. U.S. treasuries provide the collateral that backs a lot of the transactions that are central to today’s financial system. But it is also clear that the U.S. government will need to borrow the funds necessary to limit the virus’s economic fallout and to slow its spread. The Fed wants to make it very easy and very cheap for the U.S. government to do so.
Finally, the Fed wants to make sure that the banks of some of America’s biggest foreign trading partners also have access to emergency dollar financing. This basically means lending the European Central Bank (ECB), the Bank of Japan, the Bank of England, the Bank of Canada, and the Swiss National Bank the dollars they need to lend to their own financial institutions. The dollar isn’t just used in the United States, it underpins a lot of global trade and finance.
Measures implemented by Fed
To accomplish these goals, the Fed lowered interest rates to near zero. This was critical, as a lot of institutions will need to borrow over the next few months. Perhaps even more importantly, it indicated it would buy at least $700 billion worth of Treasury bonds and agency-backed mortgages—the final amount may end up being bigger—and made it easier for U.S. banks to borrow directly from the Fed. It is also using its emergency authority to set up a vehicle for lending directly to businesses, in the commercial paper market, for the first time since 2008.
Additionally, it signaled that it would now allow banks to use the capital and liquidity buffers built up over the last ten years to support higher lending and finally, the Fed agreed to lower the interest rate on its existing swap lines, which provide dollars to many (though not all) of America’s key trading partners, allowing foreign central banks to borrow dollars from the Fed and lend them to their own banks. This will provide banks outside the United States with access to longer-term financing.