Commentary by Michael Pollitt, head of credit research, Europe.
Fixed income markets have stabilised since the liquidity crunch sparked by the Covid-19 pandemic in March, but corporate bond issuers and investors still face considerable uncertainties as the spectre of downgrades looms and record issuance slows.
The sudden loss of liquidity in bonds markets midway through March, as investors moved towards the safety of cash, was reflected in credit spreads, which closely tracked the progression of the virus, spiking during the second half of the month. As the number of coronavirus infections grew, investors sought a higher premium to compensate them for the perceived risk of holding corporate debt.
Then, as governments around the world took steps to control the spread of the virus, credit spreads partly recovered. Policymakers also played a big role in taking the heat off corporate spreads, effectively serving as lenders of last resort to large parts of the credit market.
But after surmounting this initial liquidity crunch, what could the ongoing ramifications of the coronavirus crisis mean for the credit universe?
Both near-term crisis-response measures as well as longer-term shifts in corporate behaviour brought about by Covid-19 could play a key role in reshaping the universe.
Companies—like everyone else—are having to adapt to the new normal created by the Covid-19 pandemic. In the near term, most companies will still be operating in crisis mode. After responding to the initial threat to liquidity at the outset of the crisis, they will now be focusing on remaining solvent. For example, many have drastically cut capital expenditure and slashed dividends and share repurchases to meet short-term cash needs.
As the impact of Covid-19 fades, companies will shift their focus to repairing their balance sheets. Those with the strongest balance sheets, and in sectors less exposed to social distancing, could experience a V-shaped recovery. Others could see more of a U-shaped recovery as they have to take steps to actively reduce leverage. The companies in sectors facing an L-shaped recovery may have to make structural changes, such as layoffs or business closures.
More broadly, operational and societal changes that the crisis could instigate—from an appetite for greater supply chain security to increased working from home—could also have profound implications for how many corporates do business.
The looming shadow of ratings downgrades is another potential driver of change in the credit universe.
Like credit spreads, rating downgrade activity also closely tracked the progression of the virus, as the chart shows. Downgrades peaked in late March, as ratings agencies moved at unprecedented speed to reflect the new challenges facing issuers, prioritising the most-stressed sectors.
Figure 1: S&P weekly distribution of issuers affected by Covid-19 and oil prices by action type
Source: Standard & Poor’s. Rating actions are tracked at an issuer level. If an issuer has had multiple rating actions since Feb. 3, 2020, the last rating action date is reflected in the chart. Data as of June 22, 2020. Source: S&P Global Ratings Research.
The plight of “fallen angels”—bonds downgraded from investment-grade to high-yield status—has garnered special attention, in part because BBB-rated bonds have grown as a share of the credit universe in recent years.
On one hand, the disruption to the credit universe caused by fallen angels has, to date, been limited. One reason for this is that the market is getting better at pre-emptively pricing in impending ratings actions in an orderly way. Most downgrades so far during this crisis have not come as a huge surprise to the credit market.
But on the other hand, the future path of the virus, and its economic consequences, remain big unknowns. Should corporate issuers face ongoing pressure and uncertainty, there could be a second wave of ratings downgrades, which could be more disruptive than the first.
Another potential source of change lies in the supply and demand dynamics of the credit market.
Faced with the initial shock of the crisis, many companies frontloaded bond issuance to shore up their balance sheets, issuing new debt in record volumes. As the chart shows, primary issuance in Europe reached €351bn during the first five months of the year, compared with €259bn during the same period the previous year. This rise in new debt hitting the market was mostly matched by demand, thanks in part to central bank bond-buying programmes.
Figure 2: pan-European issuance (€ billions)
Source: Bloomberg. Data as at 23 June 2020.
Given this flood of supply in response to the crisis, we could well see issuance slow considerably during the second half of the year. And if demand—propped up by central bank support—remains buoyant, this could lead to a shrinking of the market, which would be a positive factor for spreads.
While this recent wave of new issuance has been significant in its scale, this—combined with recent downgrades—has not materially impacted the ratings makeup of the universe. As the chart shows, the ratings composition of the Bloomberg Barclays Euro Aggregate: Corporates Index has changed little over the past year.
Figure 3: little change to Euro Aggregate index quality since crisis began
Source: Bloomberg. Data as at 22 June 2020.
Euro Aggregate index refers to Bloomberg Barclays Euro Aggregate: Corporates Index.
Although we’re only part of the way through the crisis and we could see further downgrades, investment-grade names remain very remote to default risk and most are well equipped to adapt and survive crises like these.
Credit remains an attractive asset class. While downgrades will continue to be a threat to some of the weaker names in the universe, the stronger issuers are still appealing.
However the universe might evolve, investors should not lose sight of some of the potential benefits that an exposure to credit can provide, such as diversification, the potential for risk-adjusted returns, income and liquidity, and the valuable role it can play in complementing traditional fixed income allocations, such as government bonds, in a portfolio.
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