Differentiating between solvency and liquidity crises
Cash ascended to the throne. As the COVID-19 outbreak continues unabated through developed economies, investors scrambled to liquidate their holdings of most asset classes to hold USD. Even the traditional flight-to-quality trades were ineffective hedges against the rout; US treasuries, gold and Investment Grade (IG) bonds registered losses in the week ended 20 March in the scramble for cash.
Figure 1: Cash was crowned king in a week (16 - 20 March) that saw few precedents
Source: Bloomberg, DBS
Credit markets established as the epicentre of the rout. Market meltdowns are not unfamiliar to financial markets; what was more unique about the price action in that week was that traditionally safer assets such as US/European IG bonds underperformed more risky assets such as the S&P/MSCI EM indices. Categorising the selloff makes it clearer. As seven of the bottom-performing eight asset classes above are credit-risk related, the selloff had almost certainly emanated from the bond markets.
Figure 2: Unprecedented velocity of US corporate credit spread widening in 2020
Source: Bloomberg, DBS
Was the bond market crash all about solvency concerns? The US credit markets had been hit with a double dose of shock, with (a) economic disruption from the COVID-19 outbreak in the US anticipated to dent corporate profitability and hamper debt serviceability, and (b) lower oil prices directly hurting the upstream energy sector which comprises c.14% of US High Yield (HY) and c.17% of low BBB-rated issuers (which increases the fallen-angel risk).
While these recent events raise solvency concerns within the more highly leveraged sectors, the speed by which the broader US credit markets saw spreads widen relative to previous crises was unparalleled. Drawing equivalence from the spread widening seen during the Global Financial Crisis (GFC) and oil price collapse between 2014-15, where economic fundamentals were comparatively weak, the widening of spreads was somehow comparatively gradual back then. As such, solvency concerns alone could not have resulted in the bulk of the recent price volatility. Since 22 January, it took 63 days for spreads to widen 280 bps. Put in perspective, it took 569 days for spreads to widen by the same amount during the GFC (Figure 2).
Underpriced liquidity risk premiums responsible for the accelerated spread widening. From 2008 to present day, there have been several developments that have exacerbated the illiquidity of over-the-counter (OTC) fixed income markets, namely:
1) The rise in size and complexity of end-users – index funds, hedge funds, benchmarked-managed asset management companies (AMCs), and private wealth fuelled demand for larger tradable volumes of fixed income instruments.
2) The curtailment of Broker-Dealer ability to warehouse risk due to post-crisis era regulations.
Figure 3: Illustration of the evolution of bond OTC markets since 2008
In the same period, primary dealer inventory had declined by four times from c.USD270b pre-GFC to c.USD67b, while the US corporate bond market nearly tripled in size from USD2t to USD6t (Figure 4). Under the age of QE, bond OTC markets have been lulled into a false sense of security that bond prices would be, and indeed have been, consistently higher. It took just a week of liquidation to create a negative feedback loop of forced selling and volatility to realise that liquidity premiums should have been higher than they actually were, resulting in several instances of bond funds trading significantly below their net asset value (Figure 5). With the confluence of developments over the last decade leading up to the selloff, one could say that this had always been a liquidity crisis in the making.
Policymakers are proactively addressing the liquidity crunch. The bad news is that liquidity crises, left unaddressed, can eventually evolve into solvency crises where even profitable companies end up defaulting as a freeze in economic activity restricts access to capital. The good news is that policymakers are acutely aware of this fact, and recent measures of fiscal and monetary easing are angled with more precision towards the segments at risk – namely at liquidity in the corporate debt market.
Extraordinary crises beget extraordinary solutions. The Fed recently announced a slew of measures that have never been effected in its 106-year history, with the purchase of USD200b of corporate debt from the primary and secondary US IG corporate credit markets. This effectively makes them a lender of last resort not just to the financial system, but also to the real economy. We think that these moves, along with an anticipated fiscal package, would put a backstop to the carnage in the equity and credit markets by suppressing volatility (CIO Perspectives, 24 March).
Stay invested in credit with strong balance sheets and good liquidity. We had previously highlighted several sectors (CIO Perspectives, 9 March) – in line with our favourable view on Asia Credit – that were better positioned to ride out the crisis, and recommend that investors do not throw out any “babies with the bathwater” through indiscriminate selling. In terms of adding risk in the Asia credit market, it will likely require signs that viral infection rates are peaking (especially in the US), and a clearer understanding of the economic impact before the bond markets can resume functionality for trading. At present, market conditions remain difficult with low liquidity and large bond price volatility. As such, investors with dry powder should wait to buy the dip, and go up in credit quality when the opportunity arises, given that IG credits may be the next safe haven play with the latest extraordinary policy from the Fed. Select AT1s are also looking attractive, seeing as the prices had taken a battering in the liquidity-driven selloff; risks of banking insolvency are nowhere near as significant as that during the GFC.
Figure 4: Total size of US corporate debt has risen while primary dealer inventory has declined substantially post-GFC
Source: NY Fed, Bloomberg, DBS
Figure 5: Price divergence from NAV of iShares iBoxx IG Corporate Bond ETF the largest in the last 10 years
Source: Bloomberg, DBS
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