Before the Covid-19 crisis, market participants and regulators had warned of a parade of problems, from overleveraged corporates, heavy reliance on the dollar, deteriorating underwriting standards and thin market liquidity.
Prompt and aggressive central bank interventions, though, have meant that most of these worries never came to pass — though the crisis in corporate debt and CLOs may be only just beginning. Meanwhile, other concerns, such as moral hazard, the propriety of state aid and corporate bailouts, have been thrust rapidly aside, perhaps paving the way for problems in the post-Covid era.
“We’ve been fortunate, in a peculiar way, that the GFC was still so present in the minds of policymakers, and so much research had been done into the policy mistakes that caused the Great Depression, that the outcome on the intervention side was in many respects vastly better than expected,” says Daniela Mardarovici, co-head of multi‑sector fixed income at Macquarie Investment Management.
The Federal Reserve’s market interventions, in particular, meant that several of the big worries in the pre-Covid market failed to materialise — or were surprisingly muted in their impact.
Offering protection
“Fallen angels” have been a popular fear, partly borne out by the coronavirus crisis. The IMF’s Financial Stability Report in April 2019 flagged worries about the increasing proportion of corporate debt rated BBB, and therefore vulnerable to downgrades into high yield territory.
This, in turn, could overwhelm leveraged credit markets, as the high yield buyers struggled to absorb the giant capital structures pushed down into their market. European high yield markets saw about $126bn-equivalent of issuance last year across all categories, while a single fallen angel, Mexican state-owned oil firm Pemex, has more than $100bn of rated debt outstanding.
March, April and May have seen rating agencies fulfil the fallen angel fear, with the biggest cycle of junk downgrades in history. Firms including Ford and Fiat, Occidental Petroleum, Macy’s, Delta Airlines, Royal Caribbean Cruises, ArcelorMittal, Renault, Michael Kohrs, Spirit Aerosystem, and others are set to join HY indices.
And yet the market’s reaction has been to shrug. Investment grade and high yield bond markets continued to function relatively unruffled. The big factor has undoubtedly been Fed backing for these firms — the US central bank said it would continue to buy fallen angel debt even after downgrade, setting a ceiling on fallen angel spreads and keeping market access open for the largest firms, even in more stretched sectors.
Many analysts consider the ECB’s announcement that it was easing repo conditions for fallen angels to be a prelude to the eurozone following suit.
“What’s unusual is the extent to which policymakers care about the credit market, care about whether credit availability remains high, and care about credit spreads,” says Viktor Hjort, global head of credit strategy at BNP Paribas. “Compared with a normal downturn, the policy response has been stronger and more specifically targeted, because it’s a financial crisis with only victims, created entirely by the justifiable government response to a difficult health crisis.”
“Once the Fed intervened, and made it clear to the market that it wasn’t just bringing the bazooka, but it was busy manufacturing a lot more bazookas in the back room, you saw a return to a fair degree of normalcy in Treasuries, agency MBS and investment grade corporates,” says Mardarovici.
Dollars for all
Dollar dominance had also proved to be a persistent worry before the Covid-19 crisis, especially for students of the 2008 crisis, which propagated outwards from a seizing up in short-term dollar funding markets.
During March, as companies sought to draw down dollar funding and international banks sought to shore up liquidity, money market gauges such as the SOFR-IOER spread and the yen-dollar cross-currency basis started showing signs of strain. Commercial paper rates spiked and markets seized — prompting fears that a credit crunch could spread through banks without direct access to dollar central bank facilities.
But the Fed, mindful of 2008, moved fast, reactivating the currency swap lines with other developed market central banks that it pioneered in 2008.
“The gut reaction of the market back in March was to hoard dollar funding, but the Fed was pretty efficient in offsetting that through swap lines and its commercial paper programme,” says Hjort.
Mardarovici says: “During the GFC, the recession started in December of 2007, and TARP wasn’t announced until October 2008, so it took 10 months. Then the large fiscal stimulus bill took until the beginning of 2009. By contrast, as much as there was a lot of political bickering in Washington, it ultimately took days and weeks to adopt unprecedented measures on both the fiscal and the monetary side.”
Did regulation kill liquidity?
Bond market liquidity itself has been a popular bogeyman for the past decade or more.
The rollout of tougher capital regulations following the financial crisis made bank balance sheet a more expensive commodity, cutting back sharply on market-maker inventories and eliminating a lot of investment bank proprietary trading. Industry lobbyists argued that this would impair liquidity in the next crisis, preventing banks from purchasing bonds from their clients and stabilising any sell-off.
This partly came true— but outside a few days of true terror, banks mostly continued making two-sided markets.
“The market-making function has worked, but I would be reluctant to attribute that to regulation — in 2001 and 1991 we also didn’t really see financial accidents,” says Hjort. “I am not convinced the environment in 2008 is the right point of reference for this crisis. It is more similar to 2001. 2008 I would compare instead to 1929, it is unlike almost any other downturn in the past century or more.”
The rise of passive investment products such as ETFs in the past decade has added a further twist to the sell-off. BlackRock’s iShares division, the market leader, has added more than $1tr in net assets over the past decade. Increasingly, ETFs such as LQD, which has $49bn in US investment grade corporate bonds, are the instrument of choice for hedging — meaning they are now a critical part of market infrastructure.
The Fed also opted to step in here, recognising the increased importance of the instruments. On April 9, it said it would buy investment grade corporates, and high yield corporate bond ETFs as well — the first time the Fed had stepped into sub-IG territory.
“I don’t feel like credit market liquidity and the interaction of ETFs really has been tested. In the move wider, index products led the change, and ETFs traded at a significant discount to NAV,” says Hjort. “But that’s because the first thing investors do is reach for hedges, and ETFs are more liquid and available. My view is that ETFs served a purpose, reducing macro volatility in credit portfolios and helped mitigate the crisis effect. My view is that additional liquidity management tools are usually a positive overall.”
Lessons learned
It would be easy to take away from the Covid-19 episode the view that the Fed (followed, eventually, by the ECB) will step in and stabilise markets in a crisis. But it’s still highly questionable whether this would carry over to another downturn, especially one which originated in the financial sector. The purpose of the central banks’ interventions was not to fix the pandemic problems, but to clear a firebreak between credit markets and the effects of the virus.
“The Fed clearly cannot address the underlying economic problems, that’s impossible; we still will have near-record defaults caused by the pandemic, but it avoided having a vicious cycle created by unaddressed liquidity needs on Wall Street,” says Mardarovici.
Unlimited bailouts of corporates are not a popular policy, especially in countries where the safety net for ordinary people is threadbare. Policymakers had to move fast in March to try to preserve an economic structure that can be reactivated as lockdowns are eased, but that doesn’t mean they should become the norm.
“I think it’s possible that some regulation might be applied to corporates around managing their liquidity, perhaps a little like the bank liquidity coverage ratio,” says Hjort.
Several of the schemes for exceptional corporate support already come with strings attached, such as limits to dividends, limits to acquisitions, super-priority in any bankruptcy, or restrictions on whether companies can alter their business mix.
But the main schemes targeted at the largest companies, such as bond purchasing and commercial paper support, are mostly free of such strings.
State support will also raise questions about the future state of the corporate landscape, cross-border capital flows, and the evolution of markets, as national interests have leapt ahead of market discipline.
Although corporates may well see more oversight on the other side of the Covid-19 crisis, the largest firms are already benefiting from frankly nationalistic support packages — and the European Commission has started waving through bailout packages that might have once been tied up in months of tough negotiations over state aid.
That will help well known incumbents that employ lots of people, such as the big car firms or airlines — but after the crisis, it may start to stifle economies, through keeping zombie companies alive and would-be disruptors firmly on the doorstep.