Britain and America have moved to a war footing in dealing with the coronavirus. Announcing £350bn of government support for households and businesses on Tuesday, UK chancellor Rishi Sunak spoke of dealing with the fall-out of Covid-19 as the most serious economic challenge faced in peacetime.
In the United States, President Donald Trump has asked Congress to approve an $850bn package of federal tax cuts and expenditure, which could include sending payments to households. This once unthinkable intervention – least of all led by a Republican president – follows a day when the US Federal Reserve injected billions more dollars into money markets.
Liquidity drying up in commercial paper markets, a vital source of corporate funding, raised the spectre of the credit crunch experienced in the 2007-9 global financial crisis. Stepping in early showed the Fed’s resolve to prevent a scenario where the spike in demand for short-term credit, caused by recessionary pressures on companies’ cash flows, becomes unmanageable.
As well as buying commercial paper, the Fed decided late on Tuesday to allow its approved dealers in government debt to borrow cash against some stocks, municipal bonds and higher-rated corporate bonds. This comes on top of extending short-term repurchase agreement (repo) lending facilities to banks and longer-term support with a new $700bn programme of quantitative easing (QE).
Yet monetary policy alone, dealing with the supply issue of cash, doesn’t fix the problem which is why the ‘whatever it takes’ stance by governments to support companies and their employees is crucial.
“It’s hard for monetary packages to accurately target the right parts of the economy [sic] and people to help,” says Phil Milburn, co-manager of Liontrust Global Fixed Income team. “But what the monetary side of things can do is help finance the fiscal side with what is effectively helicopter money.”
Governments giving businesses cash they need to remain a going concern alleviates pressure on money markets and helps the banking system. Loans and corporate overdraft facilities are ample, but there would be a problem if there was widespread inability to pay them back because firms are unable to generate cash selling goods and services during the coronavirus lockdowns.
Unlike 2008-09, which was a systemic failure, Covid-19 is a crisis from outside the financial industry and the banks are much more solvent now. With hugely accommodative monetary policy supporting banks’ funding, and their customers underwritten by governments, there is more reason to think another collapse of the financial system, which would turn recession into a depression, can be averted if central banks can control the narrative in money markets and prevent panic.
Paul Hawkins, who ran credit trading businesses at RBS, Barclays & Santander, but now runs an asset management firm largely focused on bonds, notes the difference now. He says: “[In 2008-09] banks were fundamentally weaker, as expressed by Core Tier 1 ratios (the ratio of equity plus retained earnings to assets (loans) on a bank’s balance sheet). As an example, RBS (RBS) was allowed to reduce its CET1 ratio down to c4 per cent when it bought ABN Amro. This resulted in it being ill equipped for the subsequent crisis that ensued.”
He adds: “Compare that to now, RBS CET1 ratio is around 16 per cent and its balance sheet, whilst still large is nowhere near as large as it was, nor does the bank engage in anywhere as much risky investment banking business as it once did. That means it has far greater capacity to navigate any adverse economic scenario than it did before. To that end regulators have done their job by making banks safer and better equipped for scenarios such as this. Remember, though, that they always solve for the last crisis and that is why, perhaps so far, this isn’t a credit issue.”
Does the spike in credit spreads forebear disaster?
Rising spreads between the yields investors demand to hold corporate credit and the yield on government bonds has been touted as another threat to the financial system. Interpreting the situation with more nuance, Mr Hawkins says: “At the moment bond issuance will be minimal. It’s more the case that wider bond spreads reflect a reality that credit risk has increased. However, it’s too simplistic to say wider spreads will result in wide-spread defaults. The fact that the risk has gone up doesn’t necessarily mean the default scenario has to occur.”
With governments stepping in as guarantors, and central banks pumping liquidity into the banking system, short-term loan and overdraft facilities should help companies meet their obligations to pay staff and suppliers. This means that, although it is currently difficult for companies to go to the debt markets and raise new long-term bond finance, this doesn’t mean a chain reaction of smaller businesses going bust for want of cash being on hand.
Although the immediate concern of raising capital will be alleviated somewhat for many companies, long-term debt covenants are a risk. If breached, bondholders would have recourse to demand the return of their principle investment, which is of course very bad for shareholders. Some companies that have been hammered in the past month, still have headroom on covenants.
As an example, Compass Group (CPG), which provides food and support services, has seen its share price tank 47 per cent since 21 February. On Tuesday, despite trading updates and forecasts deeply affected by Covid-19, it noted it was nowhere near testing its covenants. Although the spread on its debt over government bonds has risen markedly, it could still raise finance cheaply by historic standards if buyers return to the debt market.
The covenant requirement that Compass Group’s net debt must not exceed four times Ebitda (earnings before interest, taxation, depreciation and amortisation), would restrict issuance, as would a few more quarters of bad earnings outlooks. That said, once the virus peaks, if policymakers have prevented an earnings recession from becoming a deep economic depression, bond investors may be happy to take a position with spreads offering a wide premium over government debt.
One legacy of coronavirus for investors will be that it has reminded investors of the possible risks of owning shares and bonds. Compass Group’s two per cent yielding bond, maturing in 2029, was issued in mid-2017 at a spread to gilts (UK government bonds) of 90 basis points (bps). It traded as tight as 60 basis points over its benchmark as of late February, but the spread has now widened to 170 bps over the gilt.
This seemingly seismic 110bp leap in the spread is explained by Mr Hawkins in terms of the pre-crisis investor demand for credit, which encouraged companies to issue £26bn into the sterling bond market in January alone. He notes that in a functioning primary market, “they could still likely issue ten-year debt for an all-in yield somewhere around 2.5 per cent based on existing levels. At any point in history, any responsible Chief Financial Officer (CFO) would consider this an attractive outright level.”
Liquidity issues in US Treasury market
Concerns over a credit crunch have not only been voiced relating to corporate bonds. The market for US Treasuries, which is the largest and most liquid bond market, has caused consternation with worrying anomalies appearing. Specifically, the lack of appetite for bonds that aren’t ‘on the run’ (i.e. brand-new issues) was creating a situation of tremendous demand for say new 30-year bonds but a dearth of buyers on the secondary market for issues with 29 years and 11 months to maturity.
Algorithmic trading could have something to do with the problem, which causes pricing issues with bonds and disrupts trading strategies based on spreads across the yield spectrum. The sum result is preventing the smooth functioning of the systemically important market. Liontrust’s Mr Milburn jokes that “liquidity is a coward; it always runs at the first sign of trouble”.
More seriously, he adds: “Markets are squeezy in both directions because there is very little capital prepared to stand behind any big move. Brokers are in the moving, not the storage, business and are looking to make a turn frequently, not take balance sheet positions, because the market is so volatile (they) can get stopped out by risk committees.”
The Fed’s return to QE, making them a natural buyer of less liquid off-the-run treasuries, should unblock areas of the US Treasury market which Mr Milburn feels is “still functioning, [it’s] just more volatile than for a long time”.
Scott Thiel, Blackrock’s Chief Fixed Income Strategist, relates problems in Treasury trading strategies to the gyrations in money markets. Market participants take advantage of the compression in yields and relationships between the prices of bonds on different parts of the yield curve, but these positions often need to be funded with short term finance.
Mr Thiel says: “When you have tension in the money markets, tension in financing and tension of the ability of market participants to access finance, positions which require financing tend to show stress.”
Wielding the monetary policy bazooka, the Fed has taken strong action to combat any shortage of liquidity and keep financial markets functioning. There is no visibility on how long the coronavirus crisis will last, however. Governments stepping in was vital to share the load of dealing with the economic fallout.
While uncertain, the situation is not perpetual. Investors will be looking for signals both on the health situation and from policy makers. The latter have been emphatic, now hopefully the tide can be turned rapidly against the spread of coronavirus. The FTSE 100 opening 4 per cent down on Wednesday reminds us that good news on the medical front is the prerequisite to any sustained recovery.
