Running a credit desk through the crisis of a generation
How did regulators and credit markets respond?
Fairly quickly central banks had moved to support markets. By late March, the US Federal Reserve had instituted a corporate bond-buying program. In Australia, the RBA established a Term Funding Facility to support the banks and business lending. Both moves, and others in Europe and Asia, stopped credit spreads from widening and in fact by late March, spreads were again narrowing. By way of example, Australian major banks’ five-year senior paper was trading close to a spread of 200 basis points. When the RBA came out with its funding support package, their spreads dropped back very quickly to 100 basis points and are now trading tighter than pre-pandemic levels at the start of the year.
At the peak of the sell off, subordinated bank credit spreads and some short-dated corporate bonds were at 400 basis points. You could buy into an investment-grade asset and get a yield four per cent higher than a government bond. Since the Global Financial Crisis, that number had mostly been between 100 and 200 basis points.
So, was it worth investing in credit markets?
During the period – March, April and May – investing was possible, but you needed to have conviction in your cash flow analysis and the quality of the balance sheet of the bank or corporate you were investing in. And we were focused on buying short-dated where the liquidity premia was very attractive due to the market dynamics at that point. Beyond three years, the visibility of what could happen to the risk profile of the bank or corporate, due to COVID-19, wasn’t always very clear. It was a time in the cycle where active credit managers earned their money, and rewarded fundamental investors.
Undoubtedly it was challenging. Sectors impacted by COVID-19 were beaten up and experiencing a spike in global default rates – lodging, transport and gaming, for example – those that were directly impacted by lockdowns. Retailers and property groups were also not immune. It became harder to look at what was happening and fully understand their credit profiles and the long-term implications of the pandemic.
Then there were sectors such as energy and the airports. Airports was a sector we knew well. We immediately looked at the ability of operators to turn off both capital and operating expenditure. What could management do in terms of cash flow. We had to retest all our assumptions around passenger numbers for domestic and international travel. It was an incredible period in the bond markets.
What other differences were there this time versus other crises?
Unlike previous financial crises, boards and management were much quicker to respond and raise equity this time around. During the Global Financial Crisis, equity raisings began six months after the event. This year, equity raisings began in April, one month after the pandemic hit financial markets. Management had learnt the lessons of the Global Financial Crisis and the benefit of preserving liquidity and fortressing balance sheets in the face of an uncertain outlook.
The central banks around the world, in particular the US Federal Reserve and the RBA, reacted quicker and did a good job. There will always be trade-offs in terms of cushioning the economy and supporting employment, and that has happened this time. But they kept financial markets running.
At the peak of the sell off, subordinated bank credit spreads and some short-dated corporate bonds were at 400 basis points. You could buy into an investment-grade asset and get a yield four per cent higher than a government bond. Since the Global Financial Crisis, that number had mostly been between 100 and 200 basis points.”
Another important difference this time, compared to the financial crisis, was where leverage sat. In the lead up to the financial crisis in the US, large amounts of debt sat with households. Since then, the build-up of debt in the US has been in governments and corporates as households repaired their balance sheets. In Australia, it’s the other way around. Household debt has grown but the growth of non-financial corporate debt has been slower, especially compared to the US1.
What about the next year?
It really does depend on how the virus plays out, and whether a vaccine is discovered and when it can be effectively rolled out around the globe. That is the biggest unknown for investors. In the meantime, the outcome of the US election will be a focus for the markets. So too will be how second and third waves of COVID-19, particularly in Europe play out. And of course, there’s always third quarter reporting season for investors to digest.
Investors also need to look beyond COVID-19. Many of the structural shifts and trends in industries were happening well before the pandemic hit. In many cases, COVID-19 has just accelerated those trends.
It has been an incredible year and the truism has never been so relevant – where you invest really matters.
1 Based on global debt aggregates, published by BIS
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