- The unprecedented level of liquidity currently present in the economy could potentially create problems for credit markets.
- It is resulting in higher debt leverage and looser loan terms, which could mean more defaults and lower recovery rates. A more protracted default cycle may also ensue by postponing the inevitable for some companies with very weak credit quality.
- It could create new imbalances that would pose additional risks to European bank credit profiles in adverse scenarios if banks significantly increase domestic sovereign holdings.
- Central banks' liquidity measures in response to the pandemic and following on from earlier liquidity schemes could, over time, diminish the European structured finance market's capacity to act as a funding and risk transfer tool.
- Credit investors now face a balancing act as they try to generate sufficient returns in a low-yield environment, against the backdrop of a global recession. Failure to maintain this balance could lead to a spike in credit losses.
As the COVID-19 pandemic took grip in the second quarter of 2020, credit markets feared liquidity would dry up. Now those fears have reversed: Sustained and unprecedented monetary stimulus, a lower-for-even-longer yield environment, and elevated household and corporate savings rates mean that some markets are arguably awash with more liquidity than may be good for them.
Ideally, slowly recovering economies will gradually absorb this excess. Yet, the current situation bears several risks for credit markets, five of which we explore here. We accept this list is not exhaustive and that other sectors may also be exposed to the risk of excess liquidity.
S&P Global Ratings also acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The current consensus among health experts is that COVID-19 will remain a threat until a vaccine or effective treatment becomes widely available, which could be around mid-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.
1. For U.S. Speculative-Grade Corporates, Excess Liquidity And Weaker Debt Issuance Terms Now, May Mean Lower Recoveries Later
Before the pandemic struck, debt markets were already providing generous liquidity to leveraged borrowers. Many smaller issuers were adopting highly leveraged debt structures from the start, issuing loans with weaker terms and features. Cov-lite loans--providing fewer restrictions on borrowers and fewer protections for lenders--were one such feature. They expanded from less than 10% of new first-lien loan issuance in 2010 to more than 80% in 2019 (see chart 1). Once markets reopened post the COVID-19 lockdowns, and amid concerted central bank support, cov-lite has continued to dominate new loan structures, despite rising economic concerns and the specter of rising defaults.
Set against the recent sharp downturn, a choppy, uncertain recovery, and rising defaults, a high proportion of cov-lite loans could reduce recovery prospects in the event of default. Our research indicates that cov-lite loans exhibit lower average recoveries than term loans with financial maintenance covenants (see "Settling for Less: Covenant-Lite Loans Have Lower Recoveries, Higher Event And Pricing Risks," published Oct. 13, 2020, on RatingsDirect). We have found that cov-lite loans have recovered 11% less on average (with a 34% lower median recovery) than loans with financial maintenance covenants. Cov-lite term loan structures also have higher event and pricing risks since there is no mechanism to reprice credit risk or tighten or restrict the flexibility provided by weak loan terms.
Beyond cov-lite loan structures, other weakening bond terms include higher total and first-lien debt leverage, thinner cushions of junior debt, larger and more generous EBITDA addbacks, and looser loan restrictions in general, even for credits at the low end of the speculative-grade ratings scale.
The cumulative impact of weakening debt structures and terms (including cov-lite loan terms, which are factored into our recovery analysis), has weighed on our recovery expectations in the event of default. For example, our recovery ratings on first-lien debt over the past three to four years imply average first-lien recoveries of around 65%, compared to historical recovery estimates of 75%-80%. Furthermore, our recovery estimates do not include potentially significant event risks, such as adding debt or transferring assets, that are permitted under existing debt agreements, because such events are not predictable or quantifiable and rating to a worst case scenario is not realistic or value-added, in our view. We therefore capture these events in our recovery ratings when they occur as part of our ratings surveillance.
Certain companies under significant distress in recent years have sought to exploit the flexibility in existing documents to issue super-priority priming loans or to transfer collateral from existing lenders to support new debt and alleviate near-term financial pressures (often unsuccessfully contested by existing lenders). Such issuance continued in the second and third quarters of 2020, despite rising uncertainty due to the pandemic and increasing default risk, as issuers have sought to take advantage of attractive financing conditions.
Increases in dividend recaps (see chart 2), where companies issue additional debt to pay dividends to shareholders, are another cause of higher leverage, at least in sectors where investors judge business models robust enough to carry even more debt. Speculative-grade bond issuance reached new highs in the second and third quarter of 2020, and the overall average new-issue yields for U.S. corporate bonds fell to a record low in September. While refinancing remained the dominant theme (the maturity wall continues to be deferred), dividend recaps rebounded in the third quarter, rising to their highest level since 2018 and representing 20% of U.S. leveraged loan issuance.
Faced with a prolonged recession ahead, underwriting conditions should have tightened, but due to heightened liquidity and investor demand, we continue to expect that recoveries will be lower than in the past (see "When the Cycle Turns: Assessing How Weak Loan Terms Threaten Recoveries," Feb. 19, 2019).
2. For 'CCC' Issuers In The U.S., Liquidity Stimulus May Just Be Postponing The Inevitable
It is hard to ignore that, even as central banks offer unprecedented liquidity stimulus in the primary and secondary corporate bond markets, corporate credit quality has deteriorated. The percentage of companies rated 'CCC+' or lower in the U.S. is now more than 50% higher than at year-end 2019 (see chart 3). This raises the concern that excess liquidity and low interest rates are only postponing the inevitable for some lower rated speculative-grade issuers in the most risky sectors.
The share of speculative-grade U.S. issuers rated 'B-' and lower steadily increased in the decade prior to the COVID-19 pandemic, rising from 17% at the end of 2011 to 30% as of Jan. 1, 2020. These leveraged companies were vulnerable to any slowdown, and the sudden onset of the sharp economic shutdown from COVID-19 pandemic containment measures led to a wave of downgrades, setting a new record in the second quarter. Most of these downgrades were of companies rated 'B' and lower. As a result, the share of companies downgraded to the 'CCC' category from the 'B' category spiked to an all-time high in June (see chart 4).
Historically, companies rated 'CCC+' and lower are at greatest risk of default. We therefore expect to see an increase in defaults following the sharp increase in the number of issuers rated below 'CCC+' (see chart 5). In our base-case forecast, we expect the U.S. trailing-12-month speculative-grade corporate default rate to rise to 12.5% by June 2021. However, while defaults are certainly elevated, we have seen fewer defaults to date than might have been expected given the effect of the severe economic downturn on issuers' revenue-generating capabilities.
The sheer volume and sustained nature of liquidity stimulus has come to the rescue of many issuers, so that the number of issuers transitioning to the 'CCC' rating category has quickly fallen back to pre-crisis levels after the record wave of downgrades. In fact, we are noticing even a small number of U.S. nonfinancial corporate issuer upgrades to the 'B' rating category from 'CCC' category after being downgraded in the early months of the pandemic. The main reasons are better performance than we expected, improved liquidity, and an ability to issue additional debt to alleviate upcoming maturities.
Yet, while liquidity may fuel some issuers through the short term, once credit conditions tighten they may find themselves back where they started at the beginning of 2020--weighed down by unsustainable debt structures and unable to weather the next downturn, even though they may be able to cover current interest expenses. This could prolong the default cycle because companies without a viable or sustainable business model in a post-pandemic world face increasing stress, potential default, and potentially lower recoveries.
3. European Banks' Increased Domestic Sovereign Bond Purchases Could Pose Additional Risks In Downside Scenarios
Since the start of the pandemic, European banks have been lending heavily to the real economy. At the same time, they have also been channeling part of their excess liquidity from the ECB to purchase home sovereign bonds (see "The European Sovereign-Bank Nexus Deepens By €200 Billion," published Sept. 21, 2020). They have drawn down close to €1.5 trillion since April, taking advantage of cheap financing provided by the ECB. They have also received significant deposit inflows from both households and corporates hunkering down in an uncertain environment. Deposits in the U.K. and eurozone have increased by 10% since the end of February--double the growth rate for the same period in 2019. This has created significant liquidity on banks' balance sheets, comfortably outstripping credit demand and enabling banks to park over €840 billion at the ECB between the end of February and the end of June (see chart 6).
In addition, banks have also invested a significant portion of these funds to increase their sovereign bond holdings by €210 billion since the start of 2020 as they seek to optimize use of this excess liquidity (see chart 7). We see a clear economic rationale behind banks' decision to deploy excess liquidity in this manner. First, it allows them to enhance their margins at time when profitability is likely to be under pressure. Second, it is a capital-efficient investment, as sovereign bonds don't consume capital for regulatory purposes. However, it also raises the potential risk that sizable increases in sovereign bonds holdings could revamp the sovereign-bank nexus that the European regulator has been trying to disentangle for the past few years. This interconnectedness was already tightening as a consequence of the provision of loan guarantee schemes in many countries, with both potentially becoming increasingly tied if banks continue to add sovereign risk and specifically home sovereign exposures, which already amounted to nearly €1.6 trillion at the end of June (see chart 8).
We believe this build-up in sovereign risk is only temporary, brought on by the sheer level of excess liquidity. We expect it to unwind as economies recover and savings retreat. What's more, although home sovereign bond purchases are currently higher than usual: they still only make up about 10% of the GDP of the EU 27 plus the U.K., which does not represent systemic risk. We also do not currently expect sovereign creditworthiness in the eurozone to deteriorate sharply, and certainly not in a magnitude similar to what happened during the previous crisis, when we observed a general decline of many European government credit profiles. Europe's response to the economic fallout from an unprecedented global epidemic has been unprecedented fiscal stimulus at the national and supranational level. By establishing the new Recovery and Resilience Fund, the EU has also taken the major step of mutualizing the cost of managing the virus and agreeing to make transfers to those member states hit hardest by it. Yet if, contrary to our expectations, banks continue to significantly increase sovereign holdings, this could create some new imbalances that in most adverse scenarios would pose additional risks to their credit profiles.
4. Continued Central Banks' Liquidity Support Could Diminish The European Structured Finance Market Landscape
In recent years, central bank offers of cheap liquidity via the Bank of England's Term Funding Scheme (TFS) and the ECB's targeted longer-term financing operations (TLTRO) have lowered financial institutions' incentives to issue more costly capital market debt, including covered bonds and securitizations. This has put downward pressure on European structured finance volumes. At the beginning of 2020, the impending maturity of banks' TFS borrowings was expected to spur new issuance (see chart 9). But the BoE's response to the COVID-19 pandemic included renewed provision of cheap term funding for credit institutions, which will likely hold back U.K. structured finance volumes once again. Renewed ECB stimulus is likely to result in a similar outcome in the eurozone.
As a result of these central bank liquidity measures, bank-originated structured finance issuance—which has dwindled over many years—is expected to shrink further. And while a compensating shift toward non-bank originators has helped to fill the gap, it remains to be seen whether the motivations and incentives for these non-bank issuers will sustain the market over the longer term (see chart 10).
In the eurozone, central bank activity has also directly affected the demand side of structured finance markets through quantitative easing (QE). While the ECB's securitization holdings represent only 1% of overall cumulative asset purchases under its QE program, their scale is still significant relative to the European securitization market and equivalent to about one-third of annual issuance. For new covered bond issuance, central bank purchases routinely account for 25% of investor allocations, and the ECB now holds about one-third of the eligible bonds outstanding. Partly due to the purchasing power of the ECB, most euro-denominated covered bonds now carry a negative yield.
The monetary policy response to the COVID-19 pandemic has therefore further squeezed European structured finance issuance. Central banks' provision of cheap alternative funding schemes has reduced supply, while asset purchase programs have artificially boosted demand, creating a technical squeeze.
Originators with well-established issuance programs that are central to a strategy of funding diversity in normal times are likely to maintain these programs and cultivate the respective investor base, even if cheaper funding sources are available in the short term. However, the longer central bank dominance continues, the more originators that have previously used structured finance as a marginal funding tool may no longer have sufficient incentive or capacity to maintain the necessary platforms. Similarly, an ongoing dearth of supply and artificially compressed spreads could mean that some buy-side organizations no longer have sufficient incentive to maintain the teams and processes required to participate in the market. Over time, if some market participants permanently realign their activities, the structured finance market's capacity to act as a funding and risk transfer tool could be diminished.
5. Credit Investors May Not Be Able To Balance Risk And Reward In A Global Recession With An Uncertain Outcome
One of the unintended consequences of the liquidity wave currently washing over credit markets is the reemergence of an old risk with a new twist. The old risk is the challenge for investors to balance risk and reward in the search for yield in markets in which the global stock of low-yield bonds is rising fast (see chart 11), short-term corporate yields dipped back into negative territory in Q3 (see chart 12), and accommodative monetary policy may contribute to asset price inflation and maintain the pressure on yields over the medium term. The new twist is the management of risk-reward against a global health and economic backdrop that is short on visibility and long on economic risks, as opposed to the more stable economic period preceding the pandemic. In short, how do investors deploy capital and generate returns to meet stakeholder expectations while navigating credit risk and asset-price inflation during a global recession? And what are the implications for credit markets if investors cannot achieve this balance?
At a global level some answers can be found in the rebound of equity markets since the crisis. Investors have focused in on the positive dividend yield provided by stocks, resulting in the S&P 500 in September surpassing all-time highs from February on a total return basis (see chart 13), although equity markets have fallen back more recently as COVID-19 fears rise. The price of gold, which reached a record high in August before subsequently retreating, is another partial clue, as some investors looked for alternative investments with better total return prospects. However, many large credit investors have limited equity and alternative mandates. Some have a pressing need to increase net interest margin (as in the case of banks) or generate consistent income to meet future liabilities (as in the case of pension funds and insurance companies). These investors are among a cohort that hold a growing share of credit assets. As the search for yield forces some of them into new asset classes, longer duration, or higher credit risk at a time when defaults are continuing to rise, there's a risk that a spike in losses from "yield-chasing" credit investments could further destabilize global markets.
This search for yield is already under way. Sovereign wealth funds have recently entered into partnerships with asset managers in the rapidly growing but more opaque private lending market. And some of the largest fixed-income investors have already signaled that they will consider expanding investor parameters beyond core sovereign bonds into overseas sovereign debt, corporate credit, and mortgage debt. In addition, record global corporate credit issuance to date in 2020 has been met with stellar demand. Asset reallocation will not necessarily result in increased credit risk for all, but the arrival or increase in participation of new and deep-pocketed investors may contribute to asset-price inflation and squeeze yields further, setting off a chain reaction forcing existing investors to look elsewhere. The European Covered Bond Council recently reported that the secondary market trading volume of euro-denominated covered bonds has fallen to only a quarter of the levels seen in 2015, before the ECB began its current covered bond purchase program. The U.S. speculative-grade market could provide another litmus test as to whether investors can manage this "old risk with a new twist". The market recently surpassed the previous record for annual issuance, against the backdrop of a U.S. economic recession that Federal Reserve Chairman Jay Powell has described as "without precedent in terms of scope and speed".
- Market Liquidity In A Crisis: Five Lessons From COVID-19, July 16, 2020
- Settling for Less: Covenant-Lite Loans Have Lower Recoveries, Higher Event And Pricing Risks, Oct. 13, 2020
- When the Cycle Turns: Assessing How Weak Loan Terms Threaten Recoveries, Feb. 19, 2019
- Risky Credits: The Number Of 'CCC' Category Ratings Stabilizes, Sept. 21, 2020
- A Round-Trip Ticket: Some Companies Downgraded To 'CCC+' Could Be Headed To 'B-' As The Economy Recovers, Aug. 7, 2020
- The European Sovereign-Bank Nexus Deepens By €200 Billion, Sept. 21, 2020
- When the Cycle Turns: Assessing How Weak Loan Terms Threaten Recoveries, Feb. 19, 2019
This report does not constitute a rating action.
|Primary Credit Analysts:||Patrick Drury Byrne, Dublin (00353) 1 568 0605;|
|Evan M Gunter, New York (1) 212-438-6412;|
|Luigi Motti, Madrid (34) 91-788-7234;|
|Robert E Schulz, CFA, New York (1) 212-438-7808;|
|Nicole Serino, New York + 1 (212) 438 1396;|
|Andrew H South, London (44) 20-7176-3712;|
|Steve H Wilkinson, CFA, New York (1) 212-438-5093;|
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