News of the day: High Yields, Big Business and Small, Cash Crunch and Lehman Throwback

Risk Off in the Fixed Income Market

If you ever had a conversation with me at Croc Rock or mentioned anyone of the words: “podcasts”, “yield” or “fixed income”, you know by now how much I love sounding the alarm about yield chase that has been going on in the market over the last ten years. On the investor side this manifested itself in structured products such as reverse auto-callables (explanation here) and a pile on into high yielding debt as the Bloomberg Barclays U.S. Corporate High Yield Index delivered annualized return of 9.2% since June of 2009 beating investment grade by almost 3%. On the issuance side having BBB credit rating became all the rage as Matt Levine writes in his column:

The idea is that there are a lot of investors whose mandates require them to buy (mostly) investment-grade bonds, those rated from BBB- to AAA. There are others whose mandates require them to buy (mostly) high-yield bonds, those rated BB+ or lower. There is a widespread corporate-finance view that the optimal credit rating is, more or less, BBB: Investment-grade companies can get cheaper financing and better treatment than junk-rated companies, but being high investment-grade isn’t that much better than being low investment-grade, so you might as well lever up as much as possible while still keeping an investment-grade rating.

As Chappata points out the triple B corporate debt market is now the size of over $3 trillion up from $800 billion after the last recession. However with the recent pandemic investors are clearly switching into risk off gear with massive sell offs in high yielding debt market as it plunged over 12% since its peak in February. This is partially exacerbated by movements in oil prices as the yields in energy sector rose to almost 36%. So what happens now when much of this market can not service their debt without continuous refinancing as the deals and liquidity is drying up. My personal guess is with a few collapsing zombie companies a large swath of triple B rated companies will be downgraded into double B turning them into junk and prompting an even larger sell off due to managerial requirements for investment grade funds to hold specific quality of assets depressing their prices. This would mean more difficulties for debt financing further straining the system and leading to collapses. Get out while you can.

Who is Going to Weather the Storm Better?

The struggles of traditional retailers in the last few years have been well documented. As they face pressure from online retailers and changing demographics, malls in rural areas turn into ghosts and the landlords are struggling to find commercial tenants. COVID-19 is only adding fuel to the fire with Andre Felsted from Bloomberg having a few words to say about it:

Adidas AG warned last week that the suspension of store trading in China would cost it about $1 billion in lost sales. Add in closures across the U.S. and Europe, and multiply that by the number of household names retreating, and the bill to the retail industry may be astronomical.

Stacey Widlitz of SW Retail Advisors estimates first quarter revenue will be down by 50–70% on average for global retailers.

Many of them don’t have a lot of options as the margins have already been under pressure from tariffs and it is unclear if there is anything short of layoffs they can do to minimize the damage.

As bad as this is for retailers there is an argument that small business will fair much worse. This is due to the fact that generally they will have less reserves and cash on hand to be able to sustain continuous periods of operating losses as people choose to avoid going outside to smaller establishments and prefer shopping online. Even simply looking outside at the moment downtown Toronto is looking like a ghost town and there is no foot traffic directed towards anyone of the smaller restaurants or parlors around me. There has been prolonged pressure on this segment of the market according to Connor Sen:

Since the end of 2017, companies with up to 49 workers have seen employment grow by just 130,000. Meanwhile, companies employing at least 1,000 workers have added 2.6 million employees. A prime reason for this has been the tightening labor market for service workers, with bigger businesses having an easier time increasing pay and benefits to attract people in an intensifying fight for talent. Starbucks, with billions of dollars in profits, has an easier time offering high wages and paying for workers’ college education than a local coffee shop with fewer economies of scale and where a stroke of bad luck could mean having to shut down.

The downturn sucks for everyone but it is fairly clear that smaller businesses will have a tougher time weathering it and this is where our fiscal stimulus should be directed.

Everyone Needs Cash

I have dedicated pretty much the entirety of Monday’s newsletter to liquidity problems. This was a conscious choice because generally larger and more prolonged recessions can be primarily attributed to systematic failures due to cash crunches especially if the downturn is provoked by financial markets. While “The Big Short” may lead you to believe that 2008 was a result of the subprime mortgage defaults in reality the financial system could have absorbed a much larger hit without triggering any structural issues and the actual problem laid with interbank liquidity. When a recession is triggered by a financial crisis the situation generally unfolds somewhere along these lines:

1. A build up of leverage happens in the system
2. A couple of players do not assess their risk correctly
3. As it becomes more clear that a downturn is coming or a couple of players fail, overnight funding becomes more expensive and liquidity dries up while the central bank is slow to react
4. Companies draw down on their credit lines in anticipation of a downturn
5. Liquidity evaporates further with credit becoming even less accessible and more expensive
6. Companies cannot settle obligations due to lack of cash and widespread failure occurs

While the current situation was not triggered by a financial crash it may be further exacerbated if the financial system fails following the outline I made above. John Authers has documented the presence of some of these steps already in his article:

Let’s start with the day’s most remarkable market event, which was a rise of 34 basis points in the 10-year Treasury yield, probably the world’s most important financial benchmark. That was its biggest daily move since the summer of 1987 (when the yield started as high as 8%). This was a historic move out of bonds.

The rise in the dollar probably reflects a desperate shortage of dollars needed by borrowers. (Note that emerging market credit, currencies and equities generally didn’t join in Tuesday’s rebound.)

Most reasonably of all, bond yields only reached historically low levels because of an epic squeeze in the market, so it shouldn’t be surprising to see some retreat

And as ft points out:

The need for cash is urgent in sectors worst hit by the Covid-19 outbreak, including oil, airlines and hospitality. They have rushed to trigger revolving credit lines providing pre-agreed amounts. Banks are braced for many more instructions. “Revolvers” total $729bn for non-financial companies rated by S&P, some 6 per cent of all corporate debt. This week, AB InBev opted to draw down the entirety of a $9bn loan facility. It is hardly stretched. It had $6.6bn of cash at the end of 2019.

Additionally there has been a notable build up of corporate leverage due to continuous policy of cheap credit increasing the likelihood of companies being unable to service their debt. On the bright side for all of you UBI fans, the unthinkable — helicopter money — has finally arrived from no place other than White House. (1.2$ trillion) This is extremely important as the current crisis was not triggered by a financial crash and requires more than just Fed’s plumbing to calm the markets down. However Fed can and should do more to ensure liquidity especially on the global level because whether they like it or not dollar is the reserve currency of the world. A good place to start would be opening more foreign repo facilities and providing dollar swaps for Asian region.