COVID, Credit and Corporate Treasury

I recently moderated the latest instalment in our TreasurySpring webinar series on Managing Cash in a Crisis –

A fascinating discussion around credit risk, with two people that I always enjoy talking to: our Chief Product Officer, Henry Adams; and Mark Faulkner, the Co-Founder of Credit Benchmark. Here are some of my key takeaways from the conversation…

The “everywhere risk”

Over the last decade, we have lived through one of the most benign credit environments in history. Companies at all stages of their evolution have been able to raise equity in abundance at full valuations and the debt markets have been flooded with liquidity, driving credit spreads tighter and tighter across the risk spectrum. Against this backdrop, it was easy to think of credit risk as a thing of the past, a relic of more challenging times, a problem for another day.

Yet, for the more bearish amongst us, who have witnessed how quickly liquidity can evaporate and credit can consequently deteriorate, this increasingly felt like false comfort, complacency, folly. After all, credit risk is everywhere in almost every business:

There are explicit credit risks: those that we take to banks when entrusting them with our deposits; those that we take to borrowers to whom we lend money, or to issuers of debt securities; or counterparties to our derivative trades.

Then there are implicit credit risks: to purchasers of a company’s goods with deferred payment terms; to banks/payment institutions who sit in the middle of financial transactions; and to brokers, custodians, central counterparties and exchanges who facilitate the flows of monies from one party to another or the safekeeping of assets.

Finally, there are indirect credit risks: to the service providers, administrators, distributors, technology firms that power many businesses on an outsourced basis.

In any and all of these cases, a credit default can cause significant issues for a business, irrespective of its own financial condition.

Credit risks are the landmines on a CFO/Treasurer/Risk Manager’s horizon – 95% of the time they are somebody else’s problem, an issue for a far-away land. But when the business cycle becomes a minefield, poor credit risk management can destroy a business that hasn’t carefully plotted its path through the difficulties.

Enter COVID

Back in January, Coronavirus was exactly that for those of us in the West – somebody else’s problem, an issue in a country on the other side of the world, where talks of locking down millions of people to prevent them leaving their homes felt like the over-reaction of an authoritarian State, far from our own, more civilised existence. Just six short months later, day-to-day life across the entire planet had changed beyond recognition.

We notice it most in our personal lives – not working in offices or hugging our parents, socialising according to the “rule of six”, wearing face masks to the shops, self-isolating upon return from a holiday… Adapting to these changes as individuals is hard, but it is nothing in comparison with the challenges faced by businesses that are dependent upon consumption, driven by patterns of human behaviour that are simply not possible today.

Our crystal ball is just as fuzzy as everyone else’s and I can’t pretend to have any ground-breaking insights on how the pandemic unfolds from here. But the one thing that I feel quite sure of is that the near future will not look like the recent past… and that will cause huge issues for businesses, large and small, that were quite naturally built on assumptions of stability.

So, against this rather bleak macro outlook, how should we be thinking about credit risk?

Corporate credit dynamics pre-pandemic

Even before the pandemic hit, there were some troublesome dynamics developing in the corporate credit market. Persistent low rates since the Great Financial Crisis had led to a dangerous search for yield from fixed-income investors. The result was a record amount of corporate debt issuance at record low rates. This issuance was also heavily concentrated in the lower echelons of the “investment grade” universe.

Achieving and maintaining an “investment-grade” credit rating is the gold standard for a corporation – it opens up a huge pool of potential purchasers of debt and consequently results in cheaper borrowing, an ability to run greater leverage and benefit from greater term financing flexibility, all of which can power business growth. Conversely, companies that fall outside of the investment grade universe pay higher rates to borrow and typically need to operate with lower leverage.

If a company’s business model relies on its investment-grade rating then losing that rating (becoming a “fallen angel”) can be quite challenging, in fact arguably much more challenging than if the company had never entered the investment grade ranks at all. A business model that has been built on the flexibility that an IG rating affords cannot just be changed overnight, so a downgrade can cause material disruption and trigger a downward spiral that is difficult to reverse.

Credit deterioration since March

So how has credit held up in the face of a global pandemic that has indiscriminately ravaged business models across sectors and geographies? Looking first at data from S&P, 34 issuers have been downgraded from investment grade to sub-IG/speculative grade/junk status with 126 further companies in the IG sector having been placed on negative watch since the pandemic hit. These 160 companies alone have roughly $900B of bonds currently outstanding, all of which will need to be repaid/refinanced and much of that business will need to be done in the relatively near term…

Looking at credit more broadly, S&P has already made more than 1190 downgrades so far this year, just short of the record of 1326 set in 2009 with almost 4 months of the year still to go and with a further 800 companies already on negative watch. Additionally, S&P has predicted that 290 or 15.5% of US high yield issuers and 11.5% of European HY issuers could default by next March.

Fitch: Historic and projected corporate defaults by year

Credit Benchmark data, which encapsulates a larger universe of 6,894 companies worldwide and represents the views of 40+ contributing banks that lend to these companies, offers an even bleaker picture. 578 of the companies that their contributors rated as investment grade in February had fallen out of that IG sector by the end of July. That equates to a whopping 8% of the total universe of entities that they cover.

Credit Benchmark: Fallen Angels – percentage of companies that have “fallen” by sector

I’m a cast-iron optimist at heart but I can’t help thinking that the numbers from Credit Benchmark are more believable and that those with skin in the game are more likely to provide accurate representations of reality than rating agencies who are paid by issuers desperate to maintain the stability that their IG credit rating affords. If indeed the Credit Benchmark data is an accurate reflection of reality then corporate credit is in for a pretty bumpy ride.

But at least the banks are fine, right?

Much has been made of the fact that, unlike 2008 the current crisis is not a “banking crisis”. Whilst it is definitely true that this crisis didn’t originate in the banking sector and that sector is also in [much] better shape that it was coming into the Great Financial Crisis, can we really expect the banks to be unaffected? After all, someone is going to bear the brunt of the inevitable credit losses that will result from the large amount of restructurings and defaults that we are already starting to see; and the vast majority of global lending is still provided by the banks.

We are already starting to see material credit-loss provisions being made by all of the major investment banks worldwide – to date, these have mostly been absorbed by excess trading profits and a fee bonanza from the extraordinary amounts of debt and equity capital raising that has taken place since March. But one could easily argue that the trading profits and capital raises were one-time events, whereas credit deterioration is likely to persist for several quarters to come.

Net interest margin, the traditional bedrock of the banking model has also taken a hammering with rates in a zero-bound or worse in all of the major currencies. And then there is the possibility of credit migration in the assets that support bank capital ratios – downgrades of sovereigns, CLO’s or other highly rated instruments could open up large holes in capital positions, damaging confidence, increasing borrowing costs and starting a downward spiral not at all dissimilar from that which we saw in 2008.

The data certainly suggests that there are reasons to be cautious when evaluating bank credit, with over 11% of the global banking sector exhibiting deteriorations in credit, according to data from Credit Benchmark. If we look at those banks at the upper end of the spectrum – those that are designated as Globally Systemically Important Banks (GSIBs), the proportion more than doubles to 23%, with the direction of travel over time on a downward trajectory since March. At least from the perspective of the bank credit departments that provide the data which Credit Benchmark transposes, the dials are already flashing red.

Credit Benchmark: Financial Counterpart Monitor

Conclusions

Over almost two decades in the fixed income markets, I have learnt that credit risk is an inexact science. In difficult moments, things can change very quickly and the drivers of those changes often come from factors that are difficult to predict – COVID is a prime example. Since our own painful experiences through 2008, we have been concerned that credit risk can be a major blind spot for most people/firms, particularly when evaluating correlation across sectors, markets, geographies.

In the same way as we all happily carried on shaking hands, hugging, kissing, socialising in the face of a global pandemic until we saw our own hospitals filling up with very sick patients and heard stories of friends/colleagues/relatives who were affected by COVID, it is easy to assume that credit risks are not a problem for those in a developed financial system. We are creatures of learned behaviour. And almost all of the time our reality today looks broadly the same as yesterday. And credit issues tend to “normally” be isolated to particular companies, or at worst particular geographies or sectors. So it easy to convince ourselves that we can assume that the future will be like the past; and continue doing what we have always done, even in the face of the remarkable changes that we have all experienced over the last six months.

If COVID teaches us one thing though, it should be to prepare better for events that we have not seen before, even for things which seem extremely unlikely to happen. Because if we don’t, the consequences can be disastrous. Of course, it is possible that the unprecedented scale of Central Bank intervention that we have seen since March is effective in largely neutralising the prospect of a major global credit event, though at this stage a recovery that resembles, even my 5 year-old’s lopsided interpretation of a “v” shape feels fanciful at best. But in the face of what is likely the biggest change in the credit environment since World War II, assuming that the future will look like the recent past could be a very expensive mistake.

Articles of interest

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