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Corporate Bonds - the calm before the storm?

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Patrick Kelliher

With the falls in equity markets over the past week, there has been a modest uptick in corporate bond spreads with US investment grade spreads up ca.20bps to 120bps or so. However, these are still at the lower end of recent history, with US investment grade spreads frequently trading over 150bps in the last 10 years and reaching over 300bps in the aftermath of the Lehmans default. I think the markets are not properly pricing in the risks associated with Corporate Bonds, and there is a risk of a collapse of this market on a par with the aftermath of Lehmans.

Even before the onset of Covid-19, the IMF was warning of the risks posed by rising corporate burdens and potential issues with corporate bond illiquidity in its 2019 Global Financial Stability Report [1]. On the former, the IMF estimated that in a mild slowdown, about half as severe as that suffered during the Global Financial Crisis of 2007/09, debt owed by firms unable to service the interest could rise to US$19 trillion, or 40% of total corporate debt in major economies. So a global slowdown, which may have been on the cards even before Coronavirus emerged, could trigger widespread corporate bond downgrades and defaults and a general spike upwards in bond spreads. Defaults and insolvencies could in turn exacerbate any downturn [3], creating a downward spiral.

This could cause investors to abandon corporate bonds for safer investments, which could trigger the second problem highlighted by the IMF - many are investing through corporate bond funds which may not have enough liquid assets to deal with redemptions requests. This is a risk I have been concerned about for some years [2], but the IMF have quantified this in chapter 3 of their report: in their stressed redemptions scenario, redemptions in excess of cash and high quality liquid assets give rise to an aggregate liquidity shortfall of US$160bn which affects 1/6th of all fixed income funds and half of all high yield (/sub investment grade / junk) bond funds. With redemptions exhausting cash and liquid assets, these funds would be forced to sell illiquid corporate bonds at a time when few will want to buy.

The sharp reduction in corporate bond market maker capacity since 2009 will only make matters worse - having fallen after the crisis, bond inventories more than halved again in the 5 years to end 2018 [3], indicating little capacity to take up the slack. More likely than not, redemptions will have to be met by forced sales at firesale prices, which would lead to further increases in spreads.

Of course, funds could try to buy time by invoking deferral clauses, but this may only defer the inevitable. Worse, invoking deferral clauses will add to investor panic, which may transform a steady stream of investor fund redemptions into something like a run on banks (remember Northern Risk?). The recent problems with the Woodford Equity Income Fund may seem trivial in comparison. 

In summary, with corporate bond spreads not far off historic lows, there seems little upside, but there are significant risks in terms of economic downturns leading to downgrades, defaults and higher spreads; forced sales causing spreads to spike higher; and corporate bond funds having to invoke deferral clauses preventing investors accessing their money. We may look back to this time in the same way as 2007, as the calm before the storm...

[1] https://www.imf.org/en/Publications/GFSR/Issues/2019/10/01/global-financial-stability-report-october-2019#FullReport  

[2] See my January 2014 blog "What next after property funds" - https://www.crystalriskconsulting.co.uk/what-next-after-property-funds-2.html 

[3] "Corporate Debt as a Potential Amplifier in a Slowdown", Robert S. Kaplan, President, Federal Reserve Bank of Dallas, March 5th 2019 - https://www.dallasfed.org/research/economics/2019/0305.aspx.

As part of this it notes that inventories of corporate debt held by broker-dealers declined from $29.2bn at the end of 2013 to $14.2bn at the end of 2018.

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