The Covid-19 outbreak and default rates

7 minute read

Covid-19 brings another dimension to risks for bond investments. While risk is elevated, history taught us that the world does not stop and cannot operate without companies meeting key demands. Risk management is key with bonds still serving as a key diversifier.

What started as measured accommodation and insurance cuts, by the US Federal Reserve (Fed) and other leading central banks, has quickly developed into a crisis response. Rates were cut between scheduled monetary policy meetings by 150 basis points (bp) in two weeks in March (50bp followed by another 100bp in the case of the Fed).

Bond market reaction to the crisis

Recent capital flows clearly illustrate that there are no grey areas in the fixed income market at this point. Capital flows differentiate only between safe-haven bonds and non safe-haven bonds. In situations with very high uncertainty this seems a common pattern. Emerging market, high yield and investment grade bonds have all seen record outflows, wiping out at least eight consecutive months or so of inflows. In the same time, sovereign rates, like the US 10-year treasury yield, fell to unprecedented lows of 30bp on an intraday basis.

While to some extent rates have retraced from the above lows, it is likely that yields along the curve will stay at depressed levels for some time.

It seems that the way back to some kind of “normality” will take several quarters rather than months, according to various medical research reports (e.g. from Imperial College London). Uncertainty about the path for the global economy and the virus’ financial impact, ultra-low inflation expectations and highly accommodative central banks are likely to   keep demand for safe-haven assets, like treasuries, high even if they are non yielding.

Capital flows differentiate only between safe-haven bonds and non-safe-haven bonds

Central banks step in early

In response to the crisis central banks have revamped quantitative easing again, adding to the demand for sovereign bonds: the US Fed announced unlimited purchases of treasuries and mortgage backed securities.

Meanwhile, the European Central Bank (ECB), through the Pandemic Emergency Purchase Programme (PEPP), announced to buy €750bn of bonds, which brings the monthly purchases to roughly €115bn. This is a higher run rate than previous peaks.

ECB president Lagarde said that the ECB is: “fully prepared to increase the size of our asset-purchase programmes and adjust their composition, by as much as necessary and for as long as needed”. Also the Bank of England has announced a large package by adding £250bn of purchased to make it overall 645bn bond purchases.

If the global credit crisis in 2008 and European bond crisis in 2012 served one purpose, it was to ensure the authorities have tested tools in place to implement when needed. And as a provider of liquidity, central banks brought back the majority of their crisis fighting arsenal.

As a response to signals of stress emerging in the funding market, the Fed substantially increased its repurchase agreement (repo) operations and interest rate swap lines with other foreign bond markets. At the same time, the Fed acts as a buyer of last resort to release potential stress in the commercial paper (though the commercial paper facility), money market (money market mutual fund liquidity facility) and bond dealing (primary dealer facility) markets. In a latest move the Fed added the asset backed facility (TALF), the primary market corporate credit facility (PMCCF) and the second market corporate support facility (SMCSF).

What to look out for

But it’s clear that monetary policy can only treat the symptoms while only governments and medical breakthroughs can help provide the cure. While it seems challenging to confidently allocate capital, we don’t believe that this is all black or white. With prudent selection and management, risks should be mitigated. Price dislocations also open up some opportunities. Let’s briefly look at the key areas.

Containment measures, and supply chain disruptions, put companies’ ability to generate cash flow at risk and are likely to increase pressure on economies. But at the same time, the world and demand has not stopped entirely.

Financial markets will quickly realise that there is a difference between a pharmaceutical issuer and a highly leveraged oil services issuer, for example. Without doubt, the Covid-19 crisis will have severe implications for all sectors and issuers, at least through secondary effects in the long term. At this stage, it seems more relevant, and in some ways easier, to focus on sectors that are directly affected and most exposed.

Focus on directly exposed sectors

The two most directly exposed sectors are travel and leisure, including airlines as well as the oil sector. While most airlines have cut capacity to the minimum in order to curtail costs, much of the sector is unlikely to be able to continue operating without government support. At the same time, many tourist or leisure companies are highly likely to face cash flow drying up.

In the US there are roughly $32bn of upcoming maturities

Overview of sector exposure

Beside travel and leisure we see the greatest risk in oilfield services companies and partly within pure exploration and production companies

The second, and most exposed, sector is oil, which has been hit by a demand (Covid-19) and supply (increase in oil production by Saudi Arabia) shock at the same time. A West Texas Intermediate oil price below $30 per barrel will be detrimental to all energy companies. However, while major integrated oil companies have comparably lower debt and larger cash on balance sheets, as well as levers to mitigate these challenges, we see the greatest risk in oilfield services companies and partly within pure exploration and production companies.

In the US there are roughly $32bn of upcoming maturities. To meet cash flow requirements and debt servicing needs, exploration companies may cut capital expenditure to the bare minimum, which will hurt service companies. The majority of high yield-rated exploration companies in the US may still have some hedges in place, but with one of the highest breakeven prices (approximately $50 per barrel) among producers, this puts a very large part of the sector at risk.

More shades between black and white

Apart from the above sectors, we see greater risk within the automotive manufacturing sector and sectors that are highly dependent on discretionary spending. Manufacturers and issuers from the non-food retail sectors are also exposed, particularly those that are highly dependent on international supply chains, many of which are disrupted and especially if there is high dependency on China.

Sectors with less immediate exposure seem to be telecommunications, utilities and pharmaceuticals sectors. While some of the business lines and models will also face challenges, the credits in these sectors seem more insulated from default risk.

This time it is not about banks

Banks were at the centre of the credit crisis in 2008, but appear to be outside the main focus in this crisis. Given banks are capital and liquidity providers to the economy, they are inevitably exposed. That said, banks are in a stronger position than was the case in 2008. Core equity capital ratios, for example, are up to three times higher than compared to 2007 prior the credit crisis. In addition, regulations which impose very conservative accounting assumptions, ability to withstand severe stress scenarios and a high threshold to maintain liquidity, have made the sector more resilient.

The same can’t be said about a large part of the non-financial corporate sector this time. As we have written many times before, corporate issuers are operating with record levels of leverage. Of $6tn-worth of bonds within the iBOXX USD Corporate index, half of the issuers are rated BBB while $246bn (4.1%) are only a one-notch downgrade apart from a high yield rating. According to historical data, the downgrade risk to high yield status is up to 10 times higher if a company is rated BBB- compared to BBB+.

Investment grade defaults lower in comparison

A downgrade may result in higher funding cost for issuers and higher volatility, but it doesn’t necessarily translate into defaults. The default rate for investment grade bonds has been relatively contained in the past. Since 1920 the annual average default rate in the Baa/BBB category, for example, was 0.3%. During the credit crisis in 2008 and 2009, the rate peaked in both years at around 1%. The record high was back in the 1931–1935 period, when the rate averaged 1.99%.

How does this compare to the global high yield market? During the great recession, default rates peaked at over 15% while 2008 saw rates of around 13%. In 2002, default rates peaked at 9%, which may serve as a reasonable worst-case indicator this time, given defaults were also driven by an external shock (that is, the 9/11 terrorist attack).

Spread premiums in both the investment grade and high yield bond markets have widened substantially in March. While risks for credit losses are difficult to quantify on the back of the Covid-19 crisis, it seems that spreads reflect a large part of that risk. Investment grade bond spreads in the US, for example, are averaging over 300bp spread compared to around 600bp in 2009. Spreads of US high yield bonds reached almost 1100bp compared to roughly 2200bp at the peak in 2009.

While the peak in spreads may not have been reached, it appears that more insulated and stable sectors and issuers should not only be able to manage through the crisis, but to offer an attractive risk-reward when taking pricing into consideration.

Investment grade and high yield bonds

Market Perspectives April 2020

Financial market sell-offs, in the face of unprecedented policy measures to fight the effects of the Covid-19 outbreak, suggest any rebound may be a few months away.


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