- Credit investors are facing a triple threat of risks today: COVID-19, low interest rates and falling oil prices.
- It is imperative that investors have appropriate risk protocols in place, including scrutiny of solvency and credit migration risk.
- Despite the challenging environment, many companies, even in what might be considered “at-risk” sectors, have credit defensibility.
Prevailing Against Three Hazards
Tim Lee, CFA, Senior Credit Risk and Research Officer
Credit investors today are confronted by three major hazards. First and foremost is the COVID-19 pandemic, which the International Monetary Fund (IMF) estimates will inflict a $9 trillion cumulative loss in global GDP through 2021 and trigger mass unemployment. Second, in an effort to ease the economic impact of the pandemic, global central banks have cut interest rates aggressively, affecting both the profitability of banks and pension funding ratios. Lastly, falling oil prices are negatively affecting petroleum companies, some lenders exposed to the energy sector, and even entire countries reliant on oil revenues. Together, these three hazards create a heightened level of uncertainty for credit investors. But it’s not all bad news. By adhering to a proven and disciplined risk management process, we believe that investors can continue to safely meet their income requirements even in this challenging environment.
For an issuer to be on our approved list, we must have conviction in the issuer’s capacity to pay its liabilities in full and on time. Thus, liquidity is one key factor in our solvency analysis. To survive a protracted COVID-19 lockdown, we look for issuers to have both internal liquidity resources (including cash on hand and ongoing cash flow generation) and external liquidity resources (including available credit facilities and capital market access). This liquidity must amount to a multiple of the issuer’s debts. For banks, in addition to liquid assets, we look for unencumbered assets that could potentially be monetized. We also measure the potency of their capital against a multiple of losses.
In order for an industrial issuer to land on our “approved” list, they must have a proven track record of generating positive operating cash flow through challenging recessionary periods, as well as demonstrate the ability to access cash from capital markets during the depths of market uncertainty. For banks, we generally see sufficient profitability, despite rising provision costs to maintain capital at levels that afford a cushion against past losses.
Once an issuer passes our solvency risk test, the second key is to evaluate credit migration risk. To do this, we determine drivers of credit change that are key to each issuer. Such credit drivers include cash flow generation, financial policies and, for banks, capital levels and asset quality. Once these credit drivers are defined, we can then evaluate an issuer’s credit sensitivity to the existing triple threat of hazards (COVID-19, low interest rates and falling oil prices). Through this thought process, we identify issuers with “low beta” and “high beta” to the threats in the current environment.
“Low beta” issuers are those less sensitive to the persistence of low interest rates or COVID-19–related measures, such as shelter-in-place or social distancing. Examples of “low beta” issuers include telecom companies that may refinance debt to lower interest expenses while producing steady cash flow by providing essential home internet and wireless services. Other “low beta” examples are consumer staple companies that stand to benefit from increased spending on cleaning products and retailers, such as supermarkets, mass merchants and home improvement stores, that remain open to sell non-discretionary items.
In contrast, “high beta” issuers are those whose credit profiles might be negatively impacted by an extension of pandemic-related measures or a prolonged period of depressed oil prices and low interest rates. Examples of “high beta” issuers include restaurants and hotels whose operations are disrupted by public health restrictions, energy companies impacted by low prices and diminished demand, and any banks that are highly reliant on interest income and vulnerable to asset quality deterioration.
Not All Bad News
Interestingly, upon close scrutiny of some “high beta” issuers, we have found pockets of credit defensibility. In global integrated oil and gas companies, we believe the pace of credit deterioration is controlled, given many of these investment-grade issuers can still produce positive operating cash flow due to their low production costs; the potential benefits from marginally higher natural gas prices; and actions they can take to shore up their financial positioning by reducing costs, slashing capital expenditures, halting share repurchase programs and cutting dividends.
Another area where we see credit defensibility is in the financial sector, which has spent nearly 10 years building defenses against unforeseen disruptive events such as the current triple threat. Under the watchful eye of regulators, large financial institutions around the world have been subjected to, and have passed, various stress tests of their liquidity and capital for survival without the need for government aid.
Many of these banks have also been building capital during a period where interest rates were close to zero, or below zero in some cases, just as we presently find ourselves. This means many banks have restructured to operate profitably in a low-interest rate environment. Importantly, their asset quality is well situated, with lower interest rates potentially providing support to housing and real estate markets, which are key risk exposures for many banks.
Outside of corporate credit, we also find credit defensibility in asset-backed securities with high-quality collateral where default protections remain high and collateral performance is forecasted to remain near historic norms. We estimate that subordination and excess spread levels will comfortably handle any elevated loss scenarios, such as those experienced during the 2008–2009 recession.
Looking ahead, we anticipate the current triple threat of hazards to instigate additional negative headlines and credit challenges. Additionally, we foresee rating agencies will continue to announce rating and outlook changes in the weeks and months ahead. Nonetheless, we believe our fundamental credit groundwork will help us detect and evade credit problems early, and provide us the confidence that our approved issuers will remain solvent and pay their liabilities in full and on time.
Jon Schwartz, Senior Portfolio Manager
After a historic — and not in a good way — March, confidence in financial markets has been largely restored. Signs of the COVID-19 infection peak are evident, at least in the near term, and forward-looking investors are focusing on reopening the economy and what that may bring. The relentless pace and size of the Federal Reserve’s balance sheet expansion and new fiscal stimulus from Congress have spurred a sharp recovery in the prices of risk assets. The strength of the market rebound in equities (up 25 percent from recent lows) and a significant tightening of corporate credit spreads from the extreme widening seen late March seem to set expectations for a speedy recovery in the second half of 2020 and into 2021. But has this been too much too soon?
There undoubtedly will be a significant deterioration of corporate profits, which will be replenished on corporate balance sheets with a record-breaking amount of debt issuance. This makes sense, given the generous loan guarantees provided by the Fed, and it will certainly stave off bankruptcies in the near term given the precipitous drop in economic activity.
Stay-at-home orders have impacted much of the country with 30 states on board as of March 31. Although this has been an effective tool to control the growth rate of COVID-19 cases, it has been nothing short of disastrous for economic activity and the labor markets. Retail sales dropped 8.7 percent month-over-month in March, reflecting precipitous drops in sales in the gas, restaurant and automobile industries. We expect retail activity will drop further, as the stay-at-home orders and widespread social distancing continue to impact consumer behavior. Lower spending will be driven by a substantial drop in oil prices, while lower food services expenditures will be marginally offset by the stockpiling of groceries and essential items.
Perhaps the most startling economic impact of the pandemic is illustrated by the whopping 33.6 million Americans filing initial jobless claims for the seven-week period ended May 1, 2020. This number will likely continue to rise at an alarming pace. To put this into perspective, since the beginning of 2020, initial jobless claims averaged 223,000 per week through mid-March. But for the seven weeks since March 20, an average of 4.8 million per week filed an initial unemployment claim. Some forecasters are expecting unemployment to hit 20 percent for the month of May. On May 8, nonfarm payrolls came in at an abysmal 20.5 million jobs lost in April, with the unemployment rate gapping up to 14.7 percent from 4.4 percent. These truly astounding numbers are hitting the transportation, entertainment, food services, and accommodation industries the hardest, with an especially devastating impact on small businesses.
The loss of jobs is most heavily focused on the lower wage earners. Oddly enough, this had a positive effect on average hourly earnings for the month of April. Average hourly earnings increased 4.7 percent month-over-month in April and is expected to continue increasing in May. However, this is simply a byproduct of the math. As the lower wages are removed from payrolls, what remains is a higher average hourly wage. But that only holds as long as the higher wage earners also keep their jobs. COVID-19 has clearly claimed an unprecedented number of jobs, and, for now, it’s still unclear how temporary these job losses will be once the states reverse the shelter-in-place orders.
To better understand the outlook for employment and the overall economy, it will be critical to understand how the “un-lockdown” occurs, what industries will be permitted to operate in a socially distanced fashion, and at what pace this new normal can get up and running. There are many unanswered questions. For example, which employees will be permitted back into their workplace as the economy reopens? And will demand come back immediately just because a business reopens?
While the equity market has rebounded handsomely, since the lows and fixed-income markets are operating more normally, it’s still early and too soon to make credible predictions on the pace and staying power of the recovery. Of course, we’ll be watching for clues.
Fiona Nguyen, Senior Risk & Research Officer
While the US equity and bond markets have become less volatile, thanks to various fiscal and monetary measures deployed to stabilize the economy, another unsettling trend is emerging in corporate America: credit downgrades. As the COVID-19 pandemic sweeps through the country and creates business hardships, rating agencies have started to issue more negative outlooks and downgrades to the most vulnerable sectors affected by the mandatory lockdowns. Year-to-date, the number of downgrades from both Moody’s and S&P has increased more than threefold, compared to the same period last year. The gap of new credit downgrades to upgrades is now the widest it has been in the last 10 years, with the ratio of downgrade per upgrade averaging about eight times across both rating agencies.
Is this troubling news? Credit investors can easily get sidetracked and worried when casually looking at such bleak data. But it’s important to put it into perspective and compare with other challenging periods, such as the 2009 financial crisis. While the recent downgrades seem alarming, they are not as staggering and widespread when compared to the previous crisis. Consider that during the first four months of 2009, both rating agencies issued downgrades on companies across investment-grade and high-yield space, with the proportion nearly evenly split for both categories. In 2020, downgrades have been overwhelmingly observed in high yield, making up roughly 88 percent of total downgrades. While the pandemic continues and it’s still too early to predict the final tally, this observation suggests the relative safety of investment-grade credit today.
Sector-wise, technology has been one of the most robust areas with no downgrades in the investment-grade category, highlighting its relatively low exposure to the pandemic. The financial sector, being most closely watched given the fallout from the last crisis, has been resilient this time around, thanks to stable pre-pandemic earnings, good asset quality and solid capital levels. The few downgrades in the financial sector this year have been confined to insurance companies. Of those sectors with the most downgrades, retail, energy and industrial issuers have received more red cards due to their direct exposure to plunging consumer demands amidst lockdowns as well as their relatively higher debt loads taken on before the pandemic.
All told, we should expect to see more credit rating actions toward the end of the year, as the agencies continue to assess the financial impact on various industries. However, it’s not necessarily a cause for concern. While keeping a watchful eye on the ratings, we will continue to communicate proactively with clients, and we don’t anticipate any material negative impact to portfolios at this time.
Hiroshi Ikemoto, Fixed Income Trader
Although the tenor of the financial markets has greatly improved over the past month, some segments appear less than healthy. The energy market, and oil in particular, remains a casualty of the coronavirus. During April, oil prices fell to record lows as demand plummeted. This selloff created another risk-off trade with investors rushing back into the Treasury market. The benchmark 2-year Treasury note was trading in a range of 0.20 to 0.26 percent throughout the month, while the shorter-term Treasury bill market, which has seen record surges in supply, has been trading in the low teens, basis points–wise. The record number of Americans filing for unemployment and weak corporate earnings haven’t affected the equity or the bond markets to the extent that the oil market has. It appears that many traders have already priced in the dire unemployment and economic numbers and believe that the worst has passed. Time will tell, however, if this renewed optimism is warranted.
Liquidity has come back to the bond market as the Federal Reserve’s “Alphabet Soup” of stimulus packages for the fixed-income market seems to have calmed traders. The money markets, which saw a tremendous amount of volatility and dislocation in March, also normalized to a large extent. With prime money market fund balances stabilizing and the new liquidity facilities provided by the Fed, there has been a dramatic improvement of two-way flows in the commercial paper market, and rates have been tightening by the day. In addition, the Treasury Department has been aggressively issuing T-bills that have drastically increased the supply in a market where government money market funds had been driving yields on T-bills down to zero as demand increased. The significant T-bill issuance has also lifted the rates in the repurchase agreement (repo) market, as collateral for the product grew. In general, fears that rates on government money market funds would go negative have also abated, thanks to a combination of factors, including the belief that money fund managers would simply close funds to new inflows rather than buying negative-yielding positions. These developments suggest a normalization of conditions.
Liquidity in the corporate bond market was exceptional throughout April, as this market segment doesn’t rely on huge money fund complexes to drive flows. Offers on investment-grade issues were +40 to +100 basis points (bps) vs. like-maturing Treasuries, with the bid-to-ask spread around five to 10 bps, reflecting strong demand.
Our portfolios have largely avoided the liquidity crunch of the crisis, as ample cash has been available for business needs. We continue to review, analyze and adjust our strategy of investing in investment-grade corporate debt, asset-backed securities, Treasuries and AAA-rated government and Treasury money market funds. As the coronavirus continues to affect the global economy and the psyche of investors worldwide, we remain disciplined and focused on our approach.
|Treasury Rates:||Total Returns:|
|3-Month||0.08%||ML 3-Month Treasury||0.01%|
|6-Month||0.10%||ML 6-Month Treasury||0.01%|
|1-Year||0.14%||ML 12-Month Treasury||0.01%|
Source: Bloomberg, Silicon Valley Bank as of 04/30/20
SVB Asset Management's monthly Market Insights covers current topics on portfolio management, credit considerations and market events that influence corporate investment strategy.
More on this topic
Editor's Top Picks
SVB Asset Management's Quarterly Economic Report
The SVB Asset Management Economic Report is a quarterly review and outlook on economic and market factors that impact global markets and business health. The fourth quarter was quite a quarter for markets.
SVB ASSET MANAGEMENT
For over 15 years, SVB Asset Management has helped clients in the innovation economy achieve their investment objectives by exercising fiduciary care as a trusted advisor. We excel at anticipating and responding to the ever-changing cash management needs of high growth companies.