The ongoing coronavirus is taking a heavy toll on financial markets and the psychological well-being of investors. Much of the headlines focused on heartbreaking losses in major global equity and commodity markets, disorienting spikes in equity volatility and falling Treasury yields. But the fragile foundations of the $72 trillion global corporate debt market arguably pose a greater threat to the economy and the financial system.
Since the Global Financial Crisis (GFC) of 2007-09, global monetary policies have kept interest rates low, fueling a corporate debt binge that has resulted in a 60% increase in outstanding debt. Unlike the GFC, where the problems stemmed from an over-leveraged financial sector lending to over-leveraged mortgage borrowers (facilitated by complex securitization), this crisis originated in the real economy through a collapse in demand and is not limited to not to a sector.
The longer the global pandemic persists, the more the underlying weaknesses in the balance sheets of heavily indebted companies will be exposed, triggering a wave of sell-offs, write-downs and defaults. In this scenario, a combination of market value losses and defaults will reduce investors’ appetite for corporate credit risk and eat away at financial institutions’ capital cushions, potentially destabilizing the system and restricting the flow of credit into the market. ‘economy.
A Friend of the Devil: Fallen Angels
The global corporate bond market represents approximately $13.5 trillion in circulation worldwideof which the lion’s share is investment grade. The quality securities market is where the largest and most established companies access capital to finance their medium and long-term needs. Next to Treasury bonds, the investment grade corporate bond market is generally considered the safest place to invest. This security is in question.
The composition of the market has changed considerably since the GFC. This is especially true if you look at the tip of higher quality bonds, those rated BBB. For example, in 2007, the Barclays Global Aggregate Corporate Index consisted of 26% BBB; the proportion is now increased to 50% (as of March 20, 2020). While this lowered the average credit rating of the index and increased the risk of default on average, it also increased the risk of fallen angels or bonds losing their investment status due to downgrades.
If the number of fallen angels increases significantly due to COVID-19, this would have significant implications for a wide range of investors and financial institutions, creating potentially destabilizing dynamics in the system.
One of the hardest hit groups would be insurers, especially life insurers, which are among the largest holders of investment-grade credit in the world. Insurance companies are subject to strict regulatory capital requirements which vary according to the risk of the asset. In the United States, the magnitude of the regulatory capital charge increase by two to three and a half times for bonds downgraded to junk, which would negatively impact insurers’ capital and solvency ratios. To the extent that bonds must ultimately write down or default, this would further reduce earnings and capital cushions.
Downgrades to junk status could also trigger a broader push-sell dynamic by investors who are not permitted to hold below-investment-grade assets. An important set of players in this market are high-quality index funds, which have large influxes from the GFC. These funds will – by definition – be forced to sell all fallen angels, blocking losses for their investors. While this would be bad for passive fixed income investors, the bigger concern is that this hard selling momentum will act as an accelerator that will further reinforce the cycle of price drops, downgrades, defaults and losses, thus hurting equity markets. balance sheets of financial institutions and returns to investors. and confidence, ultimately stifling the flow of credit in the economy.
The corporate sector is facing stunning revenue declines triggered by a demand shock in the real economy, the duration of which is largely unknown.
Many angels seem ready to fall with spreads on BBB bonds has recently increased at levels not seen since the GFC.
The zombies are getting closer
For smaller companies, which are generally more indebted, financing needs are usually met by banks in the leveraged loan market. According to BISthe global leveraged loan market is now worth $1.4 trillion, roughly double its size in 2008 and similar in size to the subprime mortgage market around 2007. These leveraged loans are often bundled into collateralized loan obligations (CLOs) and bought by yield-hungry investors in the tranches – equity, mezzanine and senior – including banks, insurers, asset managers and hedge funds.
Companies that borrow in the leveraged loan market are at the riskier end of the spectrum, which makes them particularly vulnerable in times of economic crisis. An increasing number of indebted borrowers are likely to be zombies. The combination of lower interest rates allowing for higher debt levels and the relaxation of bank underwriting standards has fueled this momentum for many years. In fact, more 80% of leveraged loans today are “covenant lite” — loans that offer lenders less recourse against borrowers. This represents approximately 25% before the GFC. Additionally, debt-to-earnings ratios for the segment have deteriorated overall. For example, in the first quarter of 2019 more than 40% new issues went to companies with debt to EBITDA ratios >6, a 20-year high.
In the leveraged loan market, it’s not about if downgrades and defaults will start in a recession, it’s just a matter of when and How? ‘Or’ What wrong it will be.
We fear that the answers to these questions are soon and very. The losses may end up being particularly painful for investors in equity or mezzanine tranches of CLOs – primarily insurers, asset managers and hedge funds – who will bear the brunt of impending downgrades, market value losses and subsequent defects.
One wonders to what extent the deterioration in the CLO market could trigger a larger systemic event, since banks almost exclusively hold the AAA tranches. Various central banks and international financial institutions have been monitoring the leveraged loan market as a potential systemic risk for a few years, but, US Federal Reserve Financial Stability Report summarizes: “It is difficult to know with certainty how current CLO structures and investors would perform in a period of prolonged stress. »
This time East Different
Many major segments of the global corporate debt market are facing significant pressure from the global pandemic. In the GFC, much of the distress in debt markets was due to the drying up of liquidity, causing securities to trade at discounted prices due to lack of funding, but ultimately recoup most of their value. . Today, the corporate sector faces stunning revenue declines triggered by a demand shock in the real economy, the duration of which is largely unknown. Given the massive size of the corporate debt market and the increased leverage on corporate balance sheets as this crisis approaches, large and permanent investment losses – not just temporary, liquidity and market value – are almost certain.
While central banks can help cushion shocks to credit flows, with interest rates at or near zero globally, the ability to significantly stimulate demand is severely limited. Therefore, massive fiscal interventions will likely be needed to avert a broader economic collapse. The 2,000 billion dollar recovery plan just adopted by the American government is a step in this direction. But will it be enough to stop fallen angels and zombies from infecting financial markets and the wider economy? We think this is a title that needs to get more attention.