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Recalibrating the rulebook: a focus on fundamentals

Credit fundamentals have worsened since the market sell-off began, although central banks could provide some companies with a soft landing and many firms have drawn on their credit lines in a bid to stay afloat. In our latest edition of 360°, we discuss the uptick in defaults and downgrades and consider what this means for fixed-income markets. 

The velocity of the moves in credit fundamentals and spreads – and the unbridled reach for cash from banks, corporates, and asset managers – is testament to how profoundly blindsided the economy was by the relentless spread of the coronavirus. 

While the monetary and fiscal policy responses will benefit many higher-quality companies, others will disappear altogether or be forced to restructure their debt. Financial risks will rise as debt-service obligations become more burdensome and some companies will struggle to grow into their capital structures.  

First and second-quarter earnings are set to decline by a record amount. There has also been a dramatic spike in downgrades, which are taking place at ten times the rate of upgrades within the high-yield market.

As thinly capitalised firms are locked out of refinancing markets, it is inevitable that there will be a rise in defaults. In an instinctive move to survive, companies have defended their balance sheets by cutting dividends, cancelling share-repurchase programs and reducing operating and capital expenditures. 

Firms have also drawn on their revolving credit facilities (RCFs) at an unprecedented pace. Between 9 and 27 March, the share of RCF draws went from 11% to 64.3%. Coincidentally, 56 of the 198 companies were downgraded. 

Banking: in the eye of the storm 

To help formulate our broader view of market fundamentals, we have looked at one of the sectors most affected by the crisis: banking. We see the industry as a as bellwether for the future state of credit markets.

We currently see an opportunity to invest in financials. Banks have lost about a third of their market capitalisation since the sell-off began and their debt instruments have experienced some of the greatest losses of any sector. However, markets do not seem to have factored in their strong capital position or balance-sheet strength, as well as the support they have received. 

Although the asset quality of banks has deteriorated over the last quarter, liquidity coverage ratios for the largest US banks are four-times higher than they were before 2008. Even accounting for more stringent calculation criteria, tier one and tier two ratios are also materially higher. In addition, US money-centre banks have suspended their significant share buyback programs, while capital buffers have been dropped in Europe. 

While there is uncertainty about loan performance and support for banks and borrowers, we believe the sector offers considerable value – particularly the larger ‘national champion’ banks, which will be used as the transmission mechanism for stimulus. 

Viral volatility: seeking opportunities amid the turmoil 

There is considerable uncertainty about the effect of the virus, while the impact is highly correlated across geographies, industries and asset classes. The potential outcomes are too severe to only affect equities and credit-market fundamentals have undoubtedly been impacted. 

It is clear that we will see more volatility – both above and beneath the surface – in the months ahead, which suggests there is unlikely to be a symmetrical recovery such as the one we witnessed after Q4 2018. Companies with less leveraged balance sheets are not as likely to be affected in the longer term, but in some sectors even the most defensive issuers could default in the absence of external support.