• Tom Bradley

Will COVID-19 Trigger a Debt Crisis?

The rapid spread of COVID-19 is a pandemic unlike anything experienced before with countries across the globe forced into lockdown in an attempt to contain the virus. The crisis has hit over 180 countries with over 1.3 million confirmed cases worldwide – although the true number of those infected is likely far higher due to the lack of access to tests for the virus. With normal life brought to a standstill there are growing fears over the impact that the disease may have on the capital markets.

The macroeconomy is already suffering – the US has seen a marked increase in unemployment with an increase in jobless claims of over 10 million in March and universal credit claims rising by 1 million in the UK. The equity market has also suffered with investor fears over future performance creating a mass sell-off, this has led to UK banks being forced to stop dividend payments and share buyback schemes as well as 31 S&P 500 companies either suspending or cutting dividends. Major indices have plunged across the globe with record falls in the Dow Jones industrial and NASDAQ composites. Despite a recovery in the last couple of days there remains fears of further declines due to the uncertainty surrounding the disease and how lockdown will last.

Although there are concerns around equity markets there are far greater fears over the debt markets and the potential impact that the virus may have on them and potentially the wider economy. Since the global financial crisis (GFC) corporates have experienced a decade of cheap money with borrowing costs at historically low levels. This cheap debt has been utilised heavily in the past 10 years with low central bank rates and poor yields on government bonds causing investors to seek higher returns through high yield ‘junk’ bonds (HY) which are bonds rated BB or lower. Consequently, over the past decade $9tn of debt has been raised through corporate bond sales taking the value of non-financial corporate bonds to $13.5tn at the end of 2019, approximately double the level seen at the end of 2008.

US ratings firm Moody’s has estimated that $235bn of debt is set to mature by the end of this year, and with stalling capital markets firms may struggle to refinance or repay this hence raising the risk of defaults. There is also a systemic risk posed by the crisis as where firms cut costs – potentially in an attempt to free up funds to cover debt payments, they are cutting another firms revenue. This has a knock-on effect as a growing number of firms are forced to make cuts as they see reduced levels of income and cashflow dramatically reduces in the economy. As a result it is probable that risk spreads to sectors and firms that appeared relatively safe going into the crisis.

There is particular concern over the impact of stress on the front-end of the debt markets (debt that matures in the near future). Traditionally this has been a safe market as investors can generally accurately predict the performance of companies in the near future and there is the ability for companies to refinance debt. However increasing disruption to cashflows has led to greater pressure on the front end, and with this investors are likely to become less willing to buy debt with the greater risk of default – investors don’t want to be the last one to buy debt from a company, hence they will put off their purchasing of bonds. Should this occur there will be further issues with cashflow as stalling capital markets make it impossible to refinance debt.

However, this has been countered by the Federal Reserve in the US (Fed) as they have revived their Commercial Paper Funding Facility (CPFF) from the 2008 crisis in buying front end non-financial commercial papers to alleviate the stress in this market. This is alongside Primary and Secondary Market Corporate Credit Facilities (PMCCF and SMCCF) which involves the purchasing of bonds that are due to mature in the next 5 years – this is the first time that the Fed has purchased corporate bonds. This stimulus has led to an initial rally in the debt market however there are major issues with the programme that mean it may be unable to prevent a debt crisis unless it is expanded. Currently the PMCCF and SMCCF scheme is being funded by $10bn from the treasury that can be leveraged at a 10:1 ratio therefore allowing for the purchase of $100bn of corporate bonds however this is tiny in comparison to the size of the debt market in excess of $13tn.

Perhaps the more major issue is that it only involves the purchasing of investment grade bonds (IG) which are those that are rated BBB or higher. This means that many firms who do not meet this requirement and are experiencing cashflow issues still will not have access to capital markets and remain at significant risk of default. Therefore, whilst the programme may help initially ease front end stress in the IG market it will require significant expansion should the situation become more adverse.

Arguably the most significant fear is the wave of downgrades of corporate bonds and the effect this will have on debt markets. Having come under fire for being too slow to act in the GFC ratings agencies have been quick to downgrade in this crisis with S&P global have downgrading 121 companies in the wake of the crisis. BAML estimates that $200bn worth of debt has been downgraded from IG to HY. Companies that experience this are known as ‘fallen angels’ these new fallen angels include household names such as Ford, Kraft Heinz and Macy’s.

Debt markets are currently closed to new issuance of HY bonds and have been since early March. As well as the series of downgrades makes raising cash through difficult for the original HY firms to refinance as the market becomes flooded with cheap fallen angel bonds and hence HY firms are likely to face cashflow issues. Generally, HY bonds are less involved in the front-end market and have their debt refinanced well before its maturity – it is expected that it would take a 3-6-month period of closed HY debt markets before solvency became an issue for these companies. However, there is a possibility that debt markets will be closed for this extended period and solvency fears may materialise.

Moody’s estimates have predicted a 6.5% global default rate on bonds should the lockdown be ‘short and swift’ however a longer lockdown reaching into the second half of the year could cause a soar in defaults to levels far greater than the 13% seen in 2008, with default rates predicted to be as high as 18% in this severe recession scenario.

The HY firms that may experience solvency issues are significant employers and defaults and bankruptcies for these firms would cause the already high unemployment levels to rise even further. The US government have offered some support – but like with the PMCCF&SMCCF schemes it is unlikely to be enough. They have offered 2% loans, far lower than the market rate to medium size companies who employ 500-10000 workers which would cover approximately half of the HY market. The requirements of the loan stipulate that the firm must maintain 90% of pre-crisis employment levels as well and therefore may be vital in protecting jobs. However, many companies including the household name fallen angels such as Ford employ far more than 10000 workers and cannot access the loan, hence there will be millions of jobs that the scheme will not protect. As well firms with poor cashflows and high debt levels may continue to struggle to refinance at the lowered 2% rate and hence still default.

It may be that further levels of intervention are required to prevent significant levels of default and the unemployment that will come with it. Possible methods of further intervention may come through grants or loan forgiveness schemes, similar to the measures afforded to the airline industry in recent days.

Will Covid-19 trigger a debt crisis? It depends. There is certainly a risk, especially with the downgrading of debt and the accumulation of HY debt that has occurred over the past decade. However, the Fed have move quickly to address the risk that has arisen – far quicker and much stronger in action than they did during the GFC. Although if the lockdown continues for a prolonged period and capital markets continue to stall then the rate of defaults will likely soar, and drastic action would be required to prevent a debt crisis.