Reach for yield? Regulatory arbitrage? Obscure central bank stimulus programs?!
It’s all here in a new Federal Reserve working paper by a trio of economists seeking to parse the impact of unconventional monetary policy on corporate debt.
At issue is whether a particular Fed program ended up increasing the supply of credit for U.S. companies at a time when Corporate America was still struggling to recover from the aftermath of the financial crisis, while simultaneously encouraging big investors to assume more risk in the form of higher-yielding debt securities.
‘Operation Twist,’ as the program was known, saw the central bank seeking to cheapen long-term corporate borrowing by flattening the U.S. yield curve from late 2011 to late 2012. The exact mechanics involved selling a slug of shorter-term U.S. government bonds and then using the proceeds to buy up longer-term U.S. Treasuries, thereby reducing supply and driving up demand for longer-dated debt.
“Under the plan, lower borrowing costs and increased credit availability would relieve possibly binding financial constraints on firms and households,” write Economists Nathan Foley-Fisher, Rodney Ramcharan, and Edison Yu. “But unconventional policies such as [Operation Twist] can also affect the demand for debt and the risk premia that borrowers might face.”
While talk of compressed risk premia, or the extra compensation that investors demand when buying riskier assets, has been rampant during a period of ultra-low interest rates, the paper takes an interesting approach when measuring the impact of Operation Twist on firm financing. The economists opt to examine the impact on companies with a preference for issuing longer-dated debt, or those that should in theory have benefited the most from the Fed’s twisting tactics.
“If market participants absorbed the forward guidance associated with the [Operation] and believed in segmentation and limits to arbitrage, then stock prices of firms with a higher dependence on long‐term debt should react more positively,” the economists write. “After all, because [Operation Twist] would be expected to relax financial constraints disproportionately for these types of firms in the aftermath of the financial crisis, they would now be better able to take advantage of growth opportunities.”
First, when it comes to actually loosening the floodgates for corporate credit, the paper finds a substantial impact. Companies with a tendency towards selling longer-dated debt enjoyed a statistically significant move in their share prices following the program, even when controlling for other factors.
Meanwhile, companies with a history of selling longer-dated debt also showed a marked increase in their willingness to issue bonds, thereby filling the gap left by the Fed. Here the economists find that companies with a tendency to issue long-term debt (as defined by a one standard deviation higher long-term debt ratio) saw an 8 percent faster growth rate in the stock of long-term debt in the one-year period following Operation Twist.
Using data from insurance companies–which account for 60 percent of the corporate debt holdings owned by big institutional investors–the economists find evidence of reach for yield behavior combined with regulatory arbitrage.
Insurers most dependent on income earned from U.S. Treasuries, and therefore most affected by Operation Twist, seem to have made a conscious shift into corporate debt and specifically into corporate debt rated A-, or towards the lower end of upper medium investment-grade.
The preference for A- debt may be explained by the fact that insurer capital requirement for AAA to A- bonds is identical but rises sharply for debt rated below A-. In other words, buying A- debt would allow insurers to capture an extra bit of yield, as opposed to buying an AAA-rated bond, while avoiding higher capital charges.
“Risk premia fell disproportionately for the higher-yielding A- bonds, reflecting in part an increase[d] demand for higher-yielding debt that also economize[s] on regulatory capital requirements,” wrote the authors.
Overall, the paper provides a nice snapshot of the pros and cons of monetary policy. On the one hand, Operation Twist arguably improved the U.S. economy by directing the flow of money away from longer-dated U.S. Treasuries and into corporate debt, thereby lowering borrowing costs for companies. On the other hand, the twist shifted investors’ portfolios into higher-yielding and de facto riskier assets, especially those that provided the biggest pick-up in yield while accounting for capital constraints.
“When taken together, [Operation Twist] might have been effective in relieving financial constraints and stimulating economic activity in the aftermath of the crisis for some types of firms,” the economists conclude. “But the reach for yield evidence also suggests that these policies could affect the pricing of risk in bond markets. We leave it to future research to understand better the longer-term implications of these policies…”
The full paper is available here.