Central banks unlikely to prevent solvency shock

6 min read
Eleanor Duncan, Sudip Roy

The huge liquidity stimulus announced by global central banks is unlikely to bring much solace to high-yield issuers, with many sub-investment-grade corporates potentially facing a fight to stay in business if enforced lockdowns due to the coronavirus pandemic are prolonged.

While issuers from other sectors of the bond market are beginning to return to the primary sector, the high-yield market remains paralysed as the prospect of mass defaults and bankruptcies grows.

With all but essential businesses closed by a host of governments because of the pandemic, bankers said companies that cannot access bank funding or get direct government support face a potential credit crunch.

That is despite a series of measures from central banks such as the US Federal Reserve and the European Central Bank to prop up liquidity in the financial system, including an unprecedented amount of corporate bond buying - in the Fed's case, for the first time in its history.

High-yield bonds are excluded from these programmes but some argue that there will not even be many indirect benefits for non-investment-grade credits burdened by debt.

"The authorities are still largely doing QE rather than credit easing," said Matt King, global markets strategist at Citigroup.

"They are looking at it primarily as a liquidity problem, but we see it as a solvency problem.

"Even with the Fed's policies, we have severe doubts they will make up for the solvency threats that a lot of companies will face."

King acknowledged that central banks are doing all they can but noted that they are limited by what is possible.

"If you are an airline, for example, and you have too much debt and are now suffering from a collapse in revenues but you still have fixed costs to meet, central bank liquidity won't make your situation better."

What is needed, he said, "is a massive 'extend and pretend' across the board. That's what some governments are trying to do. But it's a lot harder to get the bond markets to do that".


A slump in cashflows from the fall in global demand combined with much tighter financing conditions could result in the corporate speculative-grade default rate surging above 10% in the US and into the high single digits in Europe, according to S&P analysts.

That default rate was 3.1% in the US and 2.2% in Europe as of December, according to the ratings agency.

The S&P analysts' pessimistic outcome is a 13% default rate across US corporates by December. Oil and gas credits could hit by a distressed ratio of 94%.

Companies rated B- and below are most likely to struggle for financing and most likely to see rapid rating transitions.

No sectors are likely to be safe, although health and telecoms are more insulated than others.

"This is the extraordinary thing: to a greater or lesser extent, it's impacting all non-financial corporate sectors," said Paul Watters, S&P's head of credit research for EMEA.

US dollar high-yield spreads exceeded 1,000bp this week, breaking all historical records in terms of the speed of their ascent from the low 300s, wrote Bank of America analysts on Wednesday.

"We now think this credit cycle has turned and expect defaults to reach 9% for overall high-yield and 6% ex-energy," the BofA analysts said.


Speculative-grade companies with maturities due soon will be under the biggest squeeze in the near term, said Tim Metzgen, head of the debt advisory unit at turnaround firm Alvarez & Marsal, which oversaw the remains of Lehman Brothers after the bank's collapse in 2008.

"Companies will hold off refis for as long as they possibly can," Metzgen said. "That points to a much bigger distressed wave in the first half of next year. That is when the squeeze is really going to take place."

Some corporates are thinking about raising new money, according to bankers. But such measures are not accessible to borrowers yet because of the extreme market volatility.

"Given the volatility and elevated spreads in the market, you would have to be a motivated seller to dip your toe in this kind of market," said a London-based high-yield syndicate banker.

"If [a high-yield borrower] is looking for a funding stop-gap they'd probably do it in the private market or find a bank solution rather than go into the capital markets."

Even private equity and distressed credit funds are sitting on the sidelines until they can get a better handle on the situation, said Metzgen.

"They're not taking any positions right now. If you're a lender, you can't answer the question of what it is that you need, because there's just not enough clarity."


Bankers said the developing crisis is different to the one in 2008. The coronavirus crisis is "very much a corporate market/real world issue", said the syndicate banker.

"This is going to require an unimaginable multi-year level of analysis. Central banks spraying helicopter money is just very inefficient."

The latest data shows the global economy is heading into a deep recession. A PMI for the services sector in Germany showed a record contraction in activity, while sister surveys showed the UK's economy shrinking at a record pace.

Data firm IHS Markit said its flash US Composite Output Index, which tracks the manufacturing and services sectors, dropped to a reading of 40.5 this month. That was an all-time low and followed a reading of 49.6 in February.

The clearest evidence yet, though, of the coronavirus' devastating impact on the US economy came on Thursday with a Labor Department report showing that a record 3.3m Americans filed initial claims for unemployment benefits last week.