Should investors be wary about the fast recovery in the credit market?
Should investors be wary about the fast recovery in the credit market?
The speed of the recovery in the credit market has caught many by surprise. Since late March, credit spreads have reversed most of the widening seen earlier this year. The US investment grade (IG) option-adjusted spread (OAS) has fallen from 400 basis points (bps) to 170bps, as of 15 June. In the high yield (HY) market, the recovery was initially more tepid but HY spreads have seen a significant retracement as well.
While spreads are still elevated compared to the beginning of the year, the sharp reversal has confused those who had expected the crisis to play out over a longer period of time. Are markets right to price in such a fast recovery? Since credit spreads should reflect current and future prospects of companies, markets must have reassessed the probabilities.
In our opinion, the developments in recent months could indeed warrant a more positive outlook and narrower spreads. The unprecedented level of support has helped many companies to get through the slump. However, the questions remain: is this support sufficient and will there be a payback in the future?
Banks have kept the taps open
Importantly, companies have been able to weather the storm because bank lending has remained available despite large swaths of the economy being shut down. In March and April, US commercial and industrial loans increased by more than $600 billion. As the figure below shows, banks usually cut lending in recession, this time they have done the opposite.
Specifically, a number of companies have been able utilise credit lines set up before Covid-19. Drawing down these lines enabled companies to increase liquidity and bridge the gap in cash flows. It is not much of a surprise that the loans increased most in the consumer discretionary sector, the sector most impacted by the lockdowns.
It is a similar situation in Europe. The euro area loans to non financial corporations increased by €190 billion in March and April compared to €115 billion for the whole of 2019. Furthermore, the euro area banks have indicated that they will continue to lend despite the uncertainty.
The Federal Reserve gave a green light for investors
On 23 March, the Federal Reserve (Fed) announced that is would start purchasing corporate bonds for the first time ever, both in the primary (direct from the issuer) and the secondary market. Credit spreads peaked on the day of the announcement. In a second announcement on 9 April, the Fed stated that it will also buy HY bonds that had an investment grade rating before 22 March and HY exchange-traded funds (ETFs).
The irony is that the newly-created corporate bond facilities only became operational in mid-May and as of 12 June , the Fed has purchased just $5.5 billion of IG and HY ETFs, a drop in the ocean compared to the $750 billion maximum size of the programme. Instead, investors, emboldened by the implicit central bank backstop, have done the job for the Fed.
The primary bond market opened up already in late March and the issuance has ramped up since. As of end of May, US IG issuance has surpassed $1 trillion, twice the amount at same point in 2019. While lagging initially, US HY issuance has picked up as well, from $107 billion to $140 billion. Some of the proceeds have been to used pay back the credit lines, as outstanding loans fell slightly in May.
Echoing the fast reversal in credit spreads, inflows to credit funds have returned in volume, especially in the last few weeks. Perhaps surprisingly, inflows to HY funds have been relatively larger. With risk free yields very low across the developed markets, the inflows should continue to support the market, at least for now.
Fallen angel volume has decreased since March
In the IG market, the key worry has been a possibly large wave of downgrades to HY, given that BBB bonds made up half of the market at the beginning of 2020. In February and March, $116 billion of bonds were downgraded to HY. This included some large issuers such as Ford and Occidental Petroleum. The good news is that the downgrade or fallen angel volume was significantly lower in April and May at $21 billion.
Looking at the previous cycles in 2002 and 2009, the fallen angel volume peaked at 16% and 13% of the BBB index respectively. Currently, the tally is only at 4%, meaning that there could still be $250-$350 billion of downgrades in store, if the past is any guide.
However, equally as important as the volume of downgrades is the price at which the downgraded bonds enter the HY index. If there is a relatively small decrease in price (increase in spread), the loss for investors would be moderate and the transition more orderly.
The Fed’s promise to purchase the bonds of downgraded companies is very important in this regard. Even if a company loses its investment grade rating, it can maintain access to funding at a reasonable price. This additional flexibility was quickly reflected in the prices of fallen angel bonds, which weakened substantially in March, but quickly recovered. The spread of Ford’s bond maturing in 2022 fell from 824bps to 460bps following the Fed’s announcement in April.
High yield default rate is rising
In the HY market, defaults have started to pick up. The US HY default rate stood at 6.3% at the end of May, the highest since 2010. So far, defaults have been concentrated in the energy and telecom sectors with $35 billion of defaults year-to-date. Defaults in other Covid-19 exposed sectors have been relatively modest at $11 billion, despite some high profile names such as Hertz or JC Penny defaulting.
Moody’s expects the US HY default rate to peak at 12% at the end of 2020. This forecast implies a significant volume of defaults in the second half of 2020. Investors can find some comfort in the fact that spreads have normally peaked well before defaults, as markets tend to look forward to the potential for improving prospects of companies.
An exception to this rule is the early 2000s recession when credit spreads peaked four months after defaults in October 2002. By that time, the US economy was already a year into recovery. The current situation bears some similarities, as the default cycle follows a long period of uninterrupted growth and large build up in corporate debt.
Deteriorating corporate fundamentals mean greater vulnerability
Accommodative bank lending and extraordinary steps by the Fed have enabled companies to quickly borrow money, giving them some breathing space to weather the crisis. However, the price of this relief is that corporate fundamentals are deteriorating fast.
The first quarter data show that the net leverage of the median non-financial company in the US IG and HY index increased to a record high of 2.8x and 4.4x respectively. Furthermore, a bigger hit to earnings will come in the second quarter as economic disruption peaked in April and May. It will be some time before it is possible to gauge the full damage on corporate balance sheets.
Equity analysts expect US corporate earnings to fully recover by the end of 2021. Such a scenario could allow companies to pay back most of the emergency loans received and deleverage, at least to some extent. However, if the recovery is shallower and leverage remains high, companies will be even more vulnerable to future shocks, raising the question of debt sustainability.
But is there a cause for an immediate alarm?
Over the last decade, low interest rates have allowed companies to carry more debt. In the IG market, despite much higher leverage, the interest coverage ratio is almost unchanged compared to 2008. With bond yields at record lows, most investment grade companies should be able to continue to service their debt.
In contrast, the US HY interest coverage ratio has fallen noticeably since 2008 and in the first quarter it dropped to a record low. Consequently, HY could be more vulnerable to a protracted slump in earnings, even at record low interest rates.
Is the central bank backstop a game-changer?
Going forward, should investors be less worried about a freeze up of the credit market given the central bank backstop? While the Fed’s corporate bond purchases have been small and no company has so far requested assistance from the primary credit facility, the option is there should the need arise. The two corporate credit facilities are due to expire by 30 September 2020 but the Fed has the option to extend them.
More broadly, greater central bank involvement in the market could herald some fundamental changes. In theory, the option to borrow directly from the Fed should imply lower risk for corporate bonds, all other things equal. Furthermore, corporate bond purchases could become a permanent policy tool, the same way that government bond purchases already are.
On the other hand, the Fed might not be comfortable with this level of market intervention, especially as it has been criticised for extending the purchases to high yield bonds. Nonetheless, it could be difficult for the Fed to withdraw the support anytime soon, without destabilising the market. In the 2013 “Taper Tantrum”, the announcement that the Fed would start to reduce its government bond purchase lead to a sudden spike in government bonds yields.
Whatever is the case, the stakes are high. While the Fed can provide unlimited liquidity and keep the companies afloat, it cannot improve the profitability of companies. Research from Deutsche Bank shows that the share of “zombies” in the US, companies with debt servicing costs that are higher than profits, has increased tenfold since 2002.
It has been said that capitalism without bankruptcy is like religion without hell. Without it, there isn’t much point. Investors should be careful what they wish for.