The coronavirus crisis has sent shockwaves across global financial markets. While much of the focus to date has been on plummeting equity markets, the damage to credit markets could ultimately prove more significant for corporate issuers.
For all but the safest corporate debt, the COVID-19 outbreak is delivering a double whammy: First, it is the catalyst popping a credit bubble that has been building since the global financial crisis; and second, it is the direct cause of a seismic shift in consumer behavior that will drive an unprecedented decline in corporate earnings. While the burst bubble might have led to no more than a correction in credit, the collapse in consumer demand is likely to result in a credit crisis for many borrowers. Most worrisome, it is not clear who can solve it.
Corporate credit markets were already shaky before the outbreak, primarily due to record growth in corporate loans and bonds in the U.S. and globally. The vast increase in leverage has been systemwide and especially pervasive in market segments already shackled by debt. In the U.S., since 2007, the non-investment-grade leveraged loan market more than doubled in size to $1.3 trillion, while the dollar-denominated high yield bond market rose over 65% to $1.6 trillion, according to data provided to us by JPMorgan Chase. Further, the largest and fastest growing category within investment-grade bonds has been the lowest-rated BBB segment, which quadrupled in size over the same time frame, per S&P Dow Jones Indices.
Just as troubling have been trends toward looser restrictions on borrowers and diminishing quality of earnings. Remember when loans had stringent covenants, which imposed borrowing conditions? Apparently most of the leveraged loan market has forgotten, as more than 75% of leveraged loans issued in the past two years have not included the same requirements, per LCD, an offering of S&P Global Market Intelligence. Moreover, lenders have been increasingly willing to allow companies to inflate their cash flow numbers.
We have cautioned for months that corporate credit was particularly vulnerable to a correction. Our fears are about to be realized. Since Feb. 20, the high yield and leveraged loan markets are down 16% and 14%, respectively, as the market has begun to reprice risk. Unfortunately, we believe these losses can, and will, get worse.
Beyond just acting as a catalyst for a credit crisis, the coronavirus pandemic is having a profound negative impact on the economy. Goldman Sachs now projects second quarter GDP to fall by 34% annualized, more than any previous quarterly contraction in U.S. history.
Perhaps even more worrisome is its indefinite timing. Nobody really knows how long shelter-at-home measures will be required. The combination of disastrous earnings and uncertainty should drive risk premiums required by investors higher and cause capital to become even more dear. When lenders facing losses pull back, the correction in credit will become a crisis.
Governments and central banks have announced massive stimulus packages, including large-scale credit programs aimed at bolstering corporate borrowers. These programs are both warranted and impressive, and markets have reacted positively. In fact, investment-grade issuers raised $109 billion last week, topping the previous record by almost 50%, according to Bloomberg. However, these large-scale credit programs won’t directly benefit non-investment-grade issuers, which alone account for nearly $3 trillion of bonds and loans. Notably, last week’s investment-grade debt issuance set an all-time record, while total high yield bond issuance was $0, per Bloomberg.
We applaud fiscal and monetary stimulus but must acknowledge that those in the lower tiers of corporate credit—the have-nots—are likely to face a crisis resulting in a sharp spike in defaults. This will affect trillions of dollars of borrowings, including both non-investment-grade companies and the huge number of issuers that are downgraded from BBB as a result of the coronavirus crisis. Private capital could step up to fill this void, but with risk premiums likely to soar, the price will be steep. And so a default spiral in high yield bonds and leveraged loans will persist, as the have-nots will not have access to liquidity to stave off default.
If complacency and a lack of discipline in corporate credit over the past decade created a fire hazard, the COVID-19 outbreak has supplied the match and the fuel. We are now sounding the alarm that it can get materially worse before it gets better for a large segment of the credit market, specifically for non-investment-grade companies.
Eventually the world will come out of the crisis, but many companies will not. The government can only do so much to prop up private industry. Just as in every prior recession, however, there will be a compelling opportunity for private investors to shore up the balance sheets of many companies and produce highly attractive returns at the same time.
Bob Diamond is founder and CEO of Atlas Merchant Capital and former CEO of Barclays.
Ty Wallach is chief investment officer of credit at Atlas Merchant Capital.
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