Fiscal firepower: shock and awe in fixed-income markets

Pandora’s box: opening the fiscal coffers   

Since the coronavirus pandemic erupted, we have witnessed an immense, rapid and coordinated intervention in markets. Central banks and governments are battling against the turmoil caused by the virus, and the rulebooks for support have been rewritten (if not completely torn up). 

Monetary easing from central banks has been accompanied by an equally monumental fiscal response from governments. This includes changes to lending rules, wage subsidies, tax relief, grants, loans, bailout packages and universal income. 

Coronavirus crisis: banks lead the charge  

The banking sector, wider lending community and governments are helping companies and citizens weather the volatile economic climate. Measures used will support credit markets as they should provide a cushion against the inevitable spike in defaults.

Unlike in 2008, the current crisis has not emanated from weakness in the banking sector. As a result, authorities have moved to protect banks from the impact of the downturn and have maximised their ability to inject liquidity into the real economy.

Most regulators have followed the recommendation of the European Central Bank’s supervisory arm to ban banks from paying a 2019 dividend, which should generate an additional €30bn of capital for European banks. The UK has also followed suit with a similar request.

This move benefited credit markets, as it protects the capital position of banks. Payment of additional tier-one coupons have not been affected by the decision, although this could change if the situation deteriorates significantly. 

Banks have led the way in providing liquidity to the real economy, primarily through draws on revolving credit facilities (RCFs). This is different to 2008, when borrowers were reluctant to draw their RCFs and in some cases struggled to do so. Draws on RCFs are increasing daily and banks are shouldering the initial injections of cash into the world economy – something that reinforces the liquidity position of borrowers.

Banks and alternative lenders are also under heavy pressure to behave responsibly towards borrowers. Interest holidays have been applied in a number of European markets, where interest payments have been added to the capital value repaid at maturity and term-loan A amortisation payments have been cancelled. Generally, lenders are supporting portfolio companies that were performing before the crisis.

Governments have reinforced these initiatives with a number of national funds to support companies. Countries with significant social-support infrastructure – such as Belgium and the Nordic nations – have funds in place which support the liquidity of businesses, rather than their employees. Other countries also aim to support corporates through loan-guarantee schemes and liquidity facilities. 

Structured credit: in the firing line 

The structured-credit market is the eye of the storm. Most European securitisation is backed by loans to consumers – such as residential mortgages, car loans and credit cards – which means the drop in economic activity and decline in personal incomes has diminished the ability of consumers to reduce their debts. 

Various measures have been brought in to help consumers meet their debt obligations, including payment holidays for mortgages, credit cards and other consumer-debt products (although the obligation remains with the individual to service the debt). It will be up to lenders to decide whether to extend the payment holidays, although existing arrangements to protect borrowers remain in place.

While governments and central banks have announced supportive measures, we still believe that arrears will rise. Where these mortgages and loans have been securitised, there will be disruptions to the usual cash flows coming into the special-purpose vehicles holding them. This will affect the loans backing collateralised-loan obligations (CLOs), as well as the degree to which individuals are able to repay the debts that underly residential mortgage-backed securities and asset-backed securities. 

Structures are designed to withstand borrowers not paying interest and principal for a period of time. The length of time, as well as how much can be covered by reserves in the structure, varies. There are also support mechanisms for companies, although we expect some deterioration in the credit quality of the collateral backing CLOs as revenues have been severely hit. Defaults should increase and agencies are likely to take large-scale action on loans, which will impact the CLOs that hold them. 

In this environment, there is more of a need than ever to stress test our underlying portfolios. The scale, severity and duration of the crisis is unknown, and we are working to assess whether structures can withstand the deterioration in performance, lack of cash flow and increase in defaults. 

Nonetheless, liquidity has returned to the structured-credit market since the sell-off began. This quarter, structured-credit instruments have risen up our relative-value ranking of fixed-income assets – despite the fact that liquidity in this area was far from perfect during the sell-off. Our analysis suggests that the asset class will benefit from some of the government initiatives and that protection remains more robust than price moves suggest.

Weathering the storm: seeking upside amid the turmoil 

The coronavirus crisis has emphasised how critical active credit selection is to portfolio construction. It is vital to assess the idiosyncrasies of each trade by modelling and stress-testing the fundamentals of various economic scenarios, as well as considering the impact of technical and regulatory changes. 

At the international business of Federated Hermes, we take pride in the fact that our credit analysts tackle security selection in a high-conviction, bottom-up manner. While we face considerable uncertainty in the near term, we will continue to take an active, flexible approach to seeking opportunities throughout the fixed-income universe – something we believe should stand us in good stead in this turbulent and fast-changing environment. 

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