As the COVID-19 pandemic took hold, investors rapidly sought to reduce risk and stockpile cash. Market confidence receded very quickly, and liquidity came under significant strain. Only when central banks and governments took considerable measures to support the economy and lending environment did market liquidity start to flow again.
Can credit markets learn anything from this sudden liquidity squeeze? We've highlighted five key lessons to consider for any future periods of volatility and liquidity strain in credit markets.
1. It takes a swift, massive, and global response by central banks to contain a worldwide liquidity crisis.
With the painful experience of global financial crisis, European debt crisis, and Shanghai shock behind them, central banks around the world had well-stocked toolkits to react swiftly, strongly, and concertedly to the sudden global shock of the COVID-19 pandemic. In the biggest response in at least the past quarter of a century, the central banks in the four major currency areas expanded their balance sheets by 10 points of GDP on average. The U.S. Federal Reserve led the pack with a 15-point expansion of its balance sheet (see chart 1). In just three months, they injected an unprecedented equivalent of $2.4 trillion into the economies of these four currency areas (see chart 2).
In close cooperation with each other, the central banks have thrown all available monetary tools to use, starting with conventional rate cuts by the U.S. Federal Reserve by 150 basis points (bps), followed by the Bank of Canada (-150 bps) and the Bank of England (-65 bps) to their effective zero low bound.
Within three months, they also swiftly injected liquidity by increasing the size and duration of their lending operations to the banking system. To date, for instance, excess reserves parked by European banks at the European Central Bank (ECB) have soared by €970 billion (+56%) since the outbreak of the pandemic in March.
They eased credit conditions for the real economy by offering targeted lending programs that incentivized bank lending to corporates and especially small and midsize enterprises (SMEs). The largest increase in bank lending has been the eurozone. European banks granted €245 billion new loans to nonfinancial corporations between March and May this year, versus €133 billion in 12 months last year.
Reverting to an old tradition, the Bank of England even temporarily extended the Treasury's overdraft facility to an unlimited amount.
Resuming asset purchases was another chapter of central banks' response to the COVID-19 crisis, even more important than liquidity injection via the banking system in the case of the U.S. Fed. Since the outbreak of the crisis, the Fed has purchased outright about $2.1 trillion of assets, the ECB only half a trillion. Around 80% of these purchases are public bonds. The purchases of public bonds by central banks enabled governments--and local public authorities in the U.S.--to provide fiscal support to their economies with limited financing costs.
All central banks in major developed economies intensified their purchase of corporate assets and started or restarted buying commercial papers of nonfinancial issuers. They also delivered support to fallen angels--issuers downgraded to speculative grade ('BB+' and below) from investment grade ('BBB-' and higher). They did this either directly like the Fed in buying noninvestment-grade (IG) bonds and exchange-traded funds (ETF), or indirectly like the ECB in making them temporarily eligible as collateral assets to refinancing operations against haircuts.
Finally, central banks established standing swap lines to avoid squeezes on foreign exchange (FX) markets, which were critical to ensure dollar access, particularly for emerging markets. The swap lines granted by the Fed to other central banks increased 10x between March and May to hit $450 billion at beginning of May.
The effect of this monetary expansion, which came alongside a bold expansion of fiscal policy, is that all economic agents--households, corporates, and banks--have been able to build liquidity buffers to withstand the sudden stop in cash flows caused by the lockdowns. The household savings rate stood two points higher in the U.S. (9.6%) and the U.K. (8.4%) and four points higher in the eurozone (16.9%) at the end of the first quarter of 2020 compared to the fourth quarter of 2019.
2. Market data and investor risk tolerance are fast indicators of impending gloom.
On Feb. 27, when the U.S. had reported just two cases of COVID-19, the U.S. speculative-grade primary issuance markets began to seize up, and credit spreads started to widen dramatically. Speculative-grade credit spreads widened faster, but to lower absolute levels than during the global financial crisis, peaking less than a month later at close to 1,000 bps (see chart 3). Speculative-grade primary markets remained largely closed through most of March, as the number of new COVID-19 cases subsequently surged in the U.S. to more than 20,000 daily by the end of the month (see chart 4), only reopening after central banks intervened in late March to support primary and secondary credit market activity.
In both Germany and in the U.S., sharp spikes in equity market volatility preceded the contraction in weekly economic indicators. In Germany, the VDAX leapt to a peak of 86 on March 16 (from 15 on Feb. 13), while the weekly activity index (WAI) continued to fall to a low of -7.4% on June 14--by which time volatility had fallen by one-half (see chart 5). Similarly in the U.S., only after the VIX reached its recent peak of 83 on March 16 did the weekly economic indicator series begin to turn negative, signaling the economic contraction that had already begun in February.
Fund flows also provided a reliable indicator of what was to follow on the economic front (see chart 6). Investor risk aversion took root in the bond market, beginning with a $2.9 billion outflow from U.S. high-yield mutual funds and ETFs during the week of Feb. 26. Flows from investment-grade funds turned sharply negative in the following week, but the most pronounced outflows were in mid-March, when investors pulled over $70 billion from investment-grade funds over the two weeks ended March 26. During this time, investors globally were making a dash for cash, as they braced for the sudden economic stop. Money market funds, traditionally a defensive sector for investors in times of turmoil, accumulated more than $700 billion in fund inflows during the month of March.
Financial markets captured this turn in economic conditions faster than the economic data could be reported. The sudden shift in investor sentiment that we saw in late February marked the steepest rise in risk aversion since the global financial crisis, followed by an economic decline that was more sudden than what the U.S. had faced during that crisis. While financial markets were quick to signal this inflection point, the sharpness of the subsequent market recovery now poses the question as to whether market exuberance is consistent with future economic fundamentals.
3. Investment-grade issuance bounces back from a liquidity crisis much faster than speculative grade--and 'BB' returns before 'B'.
In the U.S., after the Fed's March 23 initial announcement that it would support the economy and general lending environment amid the evolving coronavirus pandemic, investment-grade bond issuance reacted quite quickly. But speculative-grade issuance took longer to recover (see chart 7) and only truly did so approximately three weeks later after the Fed statement of April 9. In Europe, the lag between the resumption of investment-grade bond issuance and that of speculative grade took even longer--about five to six weeks (see chart 8). It should be noted that the ECB's Pandemic Emergency Purchase Programme (PEPP) does not include the purchase of fallen-angel debt. However, in April the ECB temporarily exempted bonds downgraded to speculative grade in its collateral requirements. Additionally, the ECB and national authorities have been much more active in encouraging increased bank lending directly to corporates.
Central bank purchase programs were largely aimed at safer investment-grade assets, to limit the credit risk and potential moral hazard of purchasing lower-quality/higher-risk assets. In the U.S., the actions of the Fed have resulted in record U.S. nonfinancial corporate investment-grade bond issuance ($668 billion through June) with strong contributions from all rating segments within investment grade (see chart 9). In contrast, while speculative-grade bond issuance also hit an all-time monthly high of $48.3 billion in June, issuance at the height of the crisis was primarily limited to the highest rated 'BB' category (chart 10), illustrating that investors not only distinguished between investment grade and speculative grade but also initially between different speculative-grade segments. As markets normalize, lower rated speculative-grade issuers are now regaining increasing access to primary markets, with 'B' rated issuance reaching $17 billion in June. Therefore, while tiering is currently less pronounced, it could return if volatility and liquidity strain re-emerge.
4. In the aftermath of a crisis, the stronger may get stronger, while weaker may get weaker.
Initially, as the potential economic damage of the virus started to emerge, issuers played defense. Investment-grade corporates shored up liquidity at elevated cost in a highly uncertain environment (see chart 11). However, as central bank support continued and global economies are starting to slowly reopen, some highly rated corporates have quickly switched to offence and applied forward-looking treasury management by taking advantage of a flat yield curve to substantially term out maturities at record low financing costs. Eli Lilly issued 30-year bonds at a record yield of 2.268% in April, while Amazon issued 40-year bonds in early June with a record yield of 2.749%.
Indeed, according to LCD (an offering of S&P Global Market Intelligence), reoffer yields for issues priced since April now account for all five of the lowest 10-, 30- and 40-year rates since LCD began tracking the asset class in 2012 (see chart 12). For example, Q3 2019 previously held the record for the lowest yield for 30-year new issuance. But since April, 16 separate issuers have locked in at lower yields. This duration extension at record low yields can only further strengthen the maturity profile of many high-grade issuers, many of which also retain elevated cash balances for any future liquidity stress.
Speculative-grade issuers have not been afforded the same luxury. As the crisis deepened they were slower to regain access to capital markets. In the interim, issuers scrambled to access liquidity from a variety of sources, including drawing down on existing or new credit facilities, tapping sponsor support, accessing national support schemes, and accessing primary markets once they reopened. However, the duration of many of these facilities, whether by choice or not, is shorter than pre-crisis (see chart 13), which will bring forward refinancing risk and potentially cause challenges for some if the shape and speed of the recovery is longer than currently expected. In addition, higher financing costs and structural concessions such as an increase in the level of secured issuance, could constrain future financial flexibility for weaker speculative-grade issuers (see chart 14).
Some speculative-grade issuers were also faced with the dilemma of an urgent need for financing but a less clear path in terms of how they will manage the increased leverage and financing costs at a time when revenues are under severe strain. This could potentially lead to a protracted period of defaults as a consequence of a prolonged period of low earnings and high leverage.
5. Credit market liquidity will remain fragile while the COVID-19 health threat lingers.
While market liquidity conditions have increasingly normalized in recent weeks, we see risks that could further upset and materially constrain market liquidity over the next 100 days while the health threat from COVID-19 remains. Three major such risks are:
Withdrawal of policy support. Recent announcements from the Fed, ECB, and BOE suggest they are unlikely to reduce in scope, size, or duration their monetary support any time soon given the disinflationary pressures still playing on the global economy. However, it is less clear how long fiscal support in the form of strong subsidization of labor markets and credit guarantees provided on nonfinancial corporates can continue. The unprecedented levels of fiscal support are increasing national debt, and governments are less able to extend tax money than central banks. The risk is that fiscal support may end prematurely, resulting in bankruptcies and rising unemployment, or that it may have been only temporary and reversed later in the form of tax increases.
A second wave of virus outbreaks. A significant second wave would shake credit market confidence and alter the shape and duration of the economic recovery for issuers. It could potentially reverse capital inflows and increase financing costs, while also placing additional pressure on vulnerable corporate issuers reliant upon increased earnings from a recovery to sustain rising leverage taken on to meet near- and medium-term liquidity needs. Markets are forward-looking, and to date credit markets seem to have brushed aside the continuing rise in global cases and the re-emergence of cases both in the U.S. and Asia, preferring to place greater emphasis upon the continuing successful re-opening of many countries with the ensuing increase in economic activity. However, the growth and relative containment of the virus over the next 100 days will likely weigh on credit market sentiment, market confidence, and ultimately market liquidity.
A negative shock that tips the balance. Despite the recovery in credit markets since mid-March, due to central bank and government interventions, the recovery remains fragile and not fully retrenched. Yields for risk assets and volatility indicators are still meaningfully above pre COVID-19 levels. Negative news over the next 100 days, in relation to the progression of high potential vaccine candidates, Q2 corporate earnings reports, additional economic data, or new geopolitical developments, may not on their own pre-empt a liquidity crisis. In combination with each other, however, and on top of what has come before, they could be the final straw that tips credit markets back over the edge.
S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The consensus among health experts is that the pandemic may now be at, or near, its peak in some regions, but will remain a threat until a vaccine or effective treatment is widely available, which may not occur until the second half of 2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.
This report does not constitute a rating action.
|Primary Credit Analysts:||Patrick Drury Byrne, Dublin (00353) 1 568 0605;|
|Nick W Kraemer, FRM, New York (1) 212-438-1698;|
|Evan M Gunter, New York (1) 212-438-6412;|
|EMEA Chief Economist:||Sylvain Broyer, Frankfurt (49) 69-33-999-156;|
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