Diving into a pool without a life jacket is not very risky; however, jumping into the cold waters of the Atlantic with no land in sight and no life jacket is a whole different story. The coronavirus pandemic, which has brought many businesses to a standstill across America, created emergency measures that had never been witnessed before. Our question today is whether the actions taken by the Federal Reserve will change the way risk is perceived and managed by investors.
Our central bank, which over the last decade has been telling us that it was resolved to force Wall Street to rebuild its capital buffers so it had the wherewithal to lend in good times as well as tough times, did something it had never done before—it pledged to purchase risky corporate debt as part of its emergency package. This move, as can very well be imagined, was so aggressive, powerful and broad-based that today corporate bonds are almost all the way back to where they were before the pandemic. This includes high-yield bonds that, before the Federal Reserve’s pledge, were facing difficult times.
This deed by the Federal Reserve has worked out phenomenally for some creditors and equity holders of companies with shaky balance sheets. Will this action change the way investors look at investment risk? Will investors pay less attention to the balance sheet and go for yield, knowing that the Federal Reserve is there to bail out corporate America? During the 2008 financial crisis, big banks were bailed out while smaller institutions did not have the same aid. Every crisis appears to add another level of what economist refer to as “moral hazard.” As Mr. Nathan Sheets, chief economist of PGIM Fixed Income, has mentioned: “What the Fed is doing is necessary to get the markets going again, but on the other hand they leave investors thinking the Fed has their backs.”
This is not to say that the Federal Reserve’s approach and actions to this crisis have no merits and are not commendable. In fact, there is the distinct possibility that the policies put forth by the Federal Reserve may have well averted another financial crisis and maybe even a depression. However, it may have also altered investor incentives – to lever up for better returns. This may not only diminish the research that should be done before any and every investment but may also cause more instability in the next downturn. The onus, in the end, is not on the Federal Reserve but on us to make certain that as investors we do not lose sight of the trust that our clients have placed on us to not only provide investment guidance, but also protection of their principal.