We are nearing the end of a truly extraordinary first quarter of 2020. The past week has seen sporadic bursts of positive market sentiment, amid a constant volley of new data. In the US, the unanimous bipartisan passage of a historic $2trn stimulus bill in the Senate shored up investor sentiment for a spell, although there was still a race to get the bill passed at the end of the week.
Data showed that unemployment claims came to an unprecedented 3.3m the week before – the previous high had been 695,000 in 1982 – while on Friday, US consumer sentiment came in at an almost four-year low, its fourth-largest drop in 50 years.
Equity volatility is ebbing, but remains elevated (see figure 1). It is interesting to consider the ramifications of this for corporate debt, such as the likely spike in borrower defaults and what forbearance (or repayment relief) that banks will be expected to offer. We have heard much about the larger ‘too big to fail’ banks, but it can be instructive to look at what is happening on the ground for some of the smaller ones.
Figure 1. Volatility is still at record highs
Source: Bloomberg, as at March 2020.
Banks, bonds and default rates
Our US SMID team notes that there are a number of regional banks that are typically well-capitalised and have a good long-term track record of creditor friendly behaviour. These banks have diverse lending books which are not significantly exposed to the sectors like travel, hospitality and energy that are most affected by the crisis. Although currently trading at significant discounts, scenario tests suggest these banks have the capital to endure all bar the most extreme situations and could potentially offer some upside once the current stresses pass.
How can we expect banks to lend and enforce covenants? In the near term, banks will probably be encouraged to support their corporate and retail clients that are under strain. Our Real Estate Debt team points out that in the UK, the Financial Conduct Authority, Financial Reporting Council and Prudential Regulation Authority have issued guidance strongly encouraging banks not to restrict financial services to companies affected by the crisis. This suggests that there may temporarily be a more forgiving regime towards covenant breaches.
Credit: opportunities amid the liquidity squeeze
Within the bond market, fear that defaults will pick up has driven a steep sell-off. Our Credit team noted last week that liquidity in fixed-income markets remains challenged. The lowest-quality credits are barely trading while there has been a disproportionate sell-off in higher-quality credits such as those rated BB and BBB.
At the start of the crisis, credit exchange-traded funds (ETFs) traded at significant discounts to their net asset value, which suggested a portion of the benchmark was not repricing fast enough. This has now corrected (see figure 2) and the discount recently swung to a premium after the Federal Reserve announced a front-end buying programme and markets started to recover. Last week saw a record decline in credit spreads, as the Crossover Index fell from 750bps on Monday to 515bps on Friday. This underscores the dynamic nature of fixed-income liquidity at the moment.
Figure 2. Credit ETFs are now trading at a premium to their underlying value
Source: Federated Hermes, as at March 2020.
High yield has been particularly affected and spreads recently passed a milestone by breaching 1,000bps. Since the late 1990s, there have been about 57 weeks when spreads were above this level and in only three of these did investors lose money over the following year. For the rest, the average return was almost 40% (see figure 3).
Figure 3. Will elevated spread levels lead to higher returns?
Source: ICE bond Indices, Federated Hermes, as at March 2020.
Our Credit team also notes that while emerging-market debt corrected later than other credit classes, it has since caught up and moved sharply last week. Latin America is perceived to have the most exposure to the virus and lower commodity prices, while a certain amount of the coronavirus threat was already priced into Asian debt.
Equities: structural changes and defensive stocks
Our European equities team notes that changes that could emerge from this crisis include the in-sourcing of supply chains, curtailed travel and social interaction (with a correspondent boost in remote interactions) and a far larger role for governments.
Our SDG Equity Engagement team says that defensive companies like supermarkets have performed strongly over the period. However, it also points out that current market conditions mean that these higher-performing firms could also experience large swings in value as they are sold to meet redemptions.
The team is continuing its engagement agenda throughout the crisis and believes that this challenging period could present an opportunity for firms to adapt practices that support employees and protect their economic and mental wellbeing. The team believes that ‘decent work’, or SDG 8, is inextricably linked to other goals such good health and wellbeing (SDG 3) – the need for which is now greater than ever.
Where do we go from here?
Our Global Equities team notes that investor aversion to risk is currently at a level and duration not seen since the financial crisis (see figure 4). During 2008-9, this level of risk aversion lasted three months – which does not bode well for those hoping for a recovery in the second quarter.
Figure 5. Investors take fright
Source: Federated Hermes, as at March 2020.