Jeff Meli:              Welcome to this episode of the Flip Side.  My name is Jeff Meli.  I'm a global head of research at Barclays.  I'm joined today by Brad Rogoff, our global head of credit research.  Thanks for joining me, Brad.

Brad Rogoff:         Thanks for having me, Jeff, on this, the first virtual edition of the Flip Side.

Jeff Meli:              Yes.  That's right.  We are recording this virtually since both of us are working from home due to COVID-19 and this is going to be the latest in a series of Flip Side episodes we're planning dedicated to the economic and market implications of the virus.

                              So, in this episode, we're to talk about the credit markets.  I'm pretty worried about the credit markets.  There have been some recent strains and I think there is a risk that we see a repeat of the great financial crisis or the GFC where stress in credit was amplified to the rest of financial markets and eventually it caused problems in the real economy.

                              So, I'm specifically worried about two things, stress in very short dated usually safe parts of the credit market, known as the front end; and second, I'm worried about the potential consequences of a wave of downgrades of credit that was previously rated investment grade, getting downgraded into high-yield or junk status.  That's what we call fallen angels.  So, I think these two issues will be the focus of our discussion today.

Brad Rogoff:         Well, Jeff, these are certainly things that we've been concerned about and spending a lot of time on, but I think I'm way less worried than you.  I'm just not sure that the financial crisis is the right analogy here.  And as a result, I think you're probably overstating the risk for both the frontend and for fallen angels.

                              The U.S. Federal Reserve is taking important steps to stabilize credit markets already and it's much quicker than during the financial crisis.  And there are important provisions in the recently passed CARES Act, that's a stimulus package that was signed into law in the U.S. recently, that should keep further strains and credit from developing.  And that stimulus is about 10 percent of GDP, which is also much bigger than in 2008.

Jeff Meli:              All right.  So, before we jump in, let's talk about why the credit market is so important to the economy as a whole.  So, it is an important market for corporations to finance their operations.  So, they issue debt then they have to make periodic interest payments, and eventually, at maturity, they have to pay back the principle.

                              Now, the important feature here is that corporations must make good on these payments.  If they don't, they go into bankruptcy.  And so, that makes the credit market different from, say for example, cutting a dividend on a stock which doesn't really have operational implications for company.

                              Now, in the GFC, we found that stress in the credit market can become self-reinforcing.  So, if investors lose faith that the market is going to function smoothly, it becomes basically its own source of risk for companies and can add fuel to the fire, so to speak.

Brad Rogoff:         Sure.  Well, the financial crisis taught us some lessons.  We also learned just how bad stressing credit markets had to be before it really has some of those other repercussions.  So far, we haven't seen anything approaching that, in my opinion.  The stress in the frontend caused some underperformance of investment grade specifically and really did cause some underperformance relative to what you would expect considering the down trade in equities.

                              But away from that, even the high-yield bond market, which is obviously much riskier, has fallen about as much as we would expect given the decline in equity prices.  And that's really different from the financial crisis where you saw all of credit underperforming.  And keep in mind that the financial crisis really started in the credit markets.  But in the current volatility, I think the credit markets are implicated just like any other asset class and that's a big reason why I don't think the analogy fully holds.

Jeff Meli:              All right.  Well, one similarity between the current period and the financial crisis is that we've seen some stress in the frontend of the investment-grade market, which is the first thing I want to talk about today.

                              So, the frontend refers to bonds and other forms of debt like commercial paper that aren't maturing really soon.  So, it could be days and weeks up to, say, a couple of years.  And there's a few things to note about this market.  So the first thing to know is that under normal times this market is incredibly safe.  So companies are really unlikely to fall apart all at once, and investors have a pretty good lens into how companies are going to perform over a short period of time.  That's the first thing.  It is pretty safe market normally.

                              The second thing to note is that these bonds because it is so safe usually don't pay that much interest.

Brad Rogoff:         So, Jeff, all of these bonds are usually pretty safe.  I can't stress enough how important it is that the frontend functions for companies in the credit market.  They typically need access to the market as these bonds mature.  And in normal times, a highly rated company doesn't typically plan to repay short-dated debt with cash flows as long as they're shorter or within the leveraged target that they want to be.

Jeff Meli:              Yes.  But these aren't normal times, Brad.  So, COVID-19 has presented some unprecedented short-term challenges for some of these companies.  There are companies that we thought were perfectly viable over very long periods of time that might have very serious problems when confronted with a major disruption in their cash flows.  So, we've seen some big pressure on the front and because of that.  Think about travel companies or leisure companies where business has virtually ceased.

                              But we also saw that pressure spread, not just where you would naturally assume companies might have operational challenges.  But we started to think investors got worried about like what other investors were worrying about.  It's like a game of musical chairs where you don't want to be the last person to lend to a company.  You start to think that maybe companies won't be able to access these markets in the future.  You start to withdraw your ability to finance those companies.

                              That that leads to very severe price action, even in companies that we think had plenty of capacity to absorb short-term disruption in cash flows, the sort that we're expecting from the crisis presented by COVID-19 and that raises the prospect of sort of a cascade of business failures are collapsing in the ability to finance.

Brad Rogoff:         Certainly, we did see severe price action in the frontend.  I can't debate that obviously.  But it had nothing to do with company fundamentals in my opinions.  So, you gave some examples of some industries where we would expect these bonds to trade a lot lower and they did in those industries.

                              But at the same time, if you think about some the big tech bellwethers that you would have thought were a bit more resilient in this kind of market, they were trading off just as much as the industries that you mentioned.

                              And kind of your musical chairs analogy, I like that one, and let us play that through a little bit here.  So, what I think was happening in terms of that game is you had mutual funds that hold investment-grade bonds and they experienced record outflows.  Investors raise cash because there is a crisis developing.  And when you get record outflows, especially the short-dated mutual funds, technical selling can take over.  There's your game, musical chairs, right?

                              We do think that the technical selling was really what was driving this though and not true investor fears that these companies shouldn't be able to refinance bonds.  We need a big difference even if it means prices fall the same for some period of time because once those outflows abate – and we're starting to see that now – risk should become priced more normally.  They didn't want to take a chance on that though and they attacked the short-term part of the market by putting in facilities that would help.

                              The first thing they did was they revived the CPFF, which is the Commercial Paper Funding Facility, and that was something they brought back from a program that they put in place in 2008 to buy non-financial commercial paper in the frontend.

Jeff Meli:              OK.  Now, the CPFF, I guess, it's convenient to restart it because it's literally the exact same program that was used during the financial crisis.  But access to that program is restricted only to the very highest rated companies, so I'm not sure that's really sufficient to alleviate all the pressures that we've seen.

Brad Rogoff:         I think I have to agree with you on this one and really the market seemed to as well.  Well, the CPFF, it definitely stopped the bleeding and in the frontend.  It didn't really cause the market rally.  What would start of the market rally was the introduction of primary and secondary purchase facilities from the fed.  That really turned things around.

                              So, what I'm talking about there is what's become known as the PMCCF and the SMCCF in the always alphabet soup that comes along with these programs and that's the Primary Market Corporate Credit Facility and the Secondary Market Corporate Credit Facility.  And what these facilities are doing is they're there to buy bonds in the secondary market or in the primary market that are five-year and in from corporations and specifically from investment-grade corporations.

                              And technically, it is not even the fed that takes the risk here.  They did this before the recent bill was passed by Congress and they took capital provided by treasury that was left over from the crisis error program and the fed actually leverages that to buy bonds.  So, treasury is on the hook for first loss this year.  Given low risk in the IG frontend, they are actually able lever this 10 to 1 and that gives pretty significant buying power to unstick the frontend of the best gray market.

Jeff Meli:              All right, Brad.  I'm going to grant you that this does represent a bit of a regime shift here.  So, the U.S. Federal Reserve is actually going to be purchasing corporate bonds.  That's something that never happened even in the worst of the financial crisis.  So, that is a step towards ungluing some of these markets.

                              However, what you didn't mention was the size of the program.  So, the capital provided by treasury is only $10 billion for each of these programs.  That means even levered 10 times, which is what we think they'll lever it, that's $100 billion of purchasing in both the primary and the secondary markets.

                              $100 billion might sound like a lot.  Bbut keep in mind that the U.S. investment-grade debt market is over $8 trillion in size.  So, $100 billion, certainly a tiny little step in the right direction, but in terms of actually addressing these problems, I think it is a bit too small of a program.

Brad Rogoff:         Well, I didn't leave that out because I was trying to pull a fast one on you.  This is only the initial commitment, and really to start backstopping the market that the fed could do because of the amount that is left over from those crisis error programs.  And $100 billion is the initial size once again relative to your $8 trillion number isn't huge.  It actually will help with a couple of months of issuance, for example, in the frontend of the investment-grade market.

                              Now, what happened since then is that with the CARES Act passed by Congress this should provide the capital to increase these facilities if and when needed.  And I think what the Federal Reserve is going to try and do here is very similar to what we have seen in Europe in the past with the whatever it takes stance and really come in and expand this program if needed in the near future.

Jeff Melli:             All right.  So, do you think the fed is going to help ease the pressures in the frontend?  Then let's pivot to my second big concern where I think the Federal Reserve is much less likely to come to the rescue and that's fallen angels and will he overwhelm the high-yield market?

                              So, keep in mind, fallen angels means companies that were previously rated investment-grade, so very safe, but run into some kind of an operational problem, for example, because of cash flow issues posed by COVID-19 and they get downgraded into high-yield or junk status.  Now, this presents a problem because the high-yield market was shot to new issuance for several weeks.

                              If you saw a major wave of downgrades of previously safe companies, that could make it difficult to impossible for the existing high-yield universe to refinance the debt that they have maturing.

Brad Rogoff:         Well, the high-yield market certainly gets a lot less sympathy.  But the high yield market tends to have less frontend maturities and that because those – it's going to get a lot less sympathy and there are points in time that the high yield market could be closed for refinancing.  So, companies tend to refinance bonds well before they come due.

                              And as a result, it can survive a period of limited new issuance without major consequences long-term.   You actually saw this as recently as December 2018.  You kind of need the market to be closed for three, six months before solvency concerns really set in for these high-yield companies just from refinancing debt.

Jeff Meli:              All right.  But clearly, if there is no new issuance coming, that means is a lack of appetite for new risk from investors.  Now, that lack of appetite is certain material because there is new risk coming.  It's just not coming in the form of new bonds.  It is coming in the form of downgrades from investment-grade.

                              So, we got a massive amount of BBB issuance over the past several years.  Triple B is the lowest tier of investment-grade.  It is now about 50 percent of the investment-grade market.  We've already started to see some of those companies get downgraded to high-yield.  Keep in mind, the rating agencies got criticized during the last crisis for being too slow to act.  They are definitely not making that mistake again.  And as a result, this wave of downgrades could actually keep the high-yield market shot for long enough to hit some of these triggers that you're talking about.

Brad Rogoff:         Yes.  Certainly coming fast and furious from rating agencies right now.  Look, 18 months ago, when many were worrying about being BBB bubble, we believe it was overblown.  In fact, in 2019, we saw the largest net rising star year ever, meaning companies getting upgraded to investment-grade from high-yield.  Now, we're going to be faced with the opposite pretty clearly and we're estimating about 175 billion to 200 billion of downgrades in the form of fallen angels from investment-grade to high-yield.

                              The estimates heavily skewed sector wise.  And really, the consumer is cyclicals.  Autos are included in that.  And energy companies with over 90 billion already this month being downgraded with those sectors leading the way and some others would represent a record year in terms of fallen angels.

                              We still do not think will be as bad as some fear because of the non-cyclical nature of a lot of the BBB issuance you are referencing over the years.  And in fact, healthcare, pharma, consumer products, companies that tend to be more stable are the biggest part of the BBB to BBB minus investment grade market.

Jeff Meli:              Well, Brad, 175 billion to 200 billion of downgrades would still represent about 15 percent of the high-yield market.  That's a pretty substantial increase in the amount of high-yield debt for a market that hasn't grown it all in the past four years.  And I would point out that high-yield companies actually employ a substantial number of people.  So, the solvency questions around that market actually matter a lot or quickly turns into an unemployment question.

Brad Rogoff:         At most I really do see this pressure in valuations.  I don't see the fallen angel phenomenon causing solvency problems.  So, (it) may put pressure on high-yield prices.  Although I note that over the years, investment grade investors have been much better about having buckets to hold onto these bonds after downgrade.  And historically, the low point prices for fallen angels that survive is actually at the time of downgrades from investment-grade to high-yield, which makes them good investments to hold onto.

                              Also, the average dollar price is around 70 for these fallen angels and that means less of the capital outlay.  It also means the price is below the rest of the high-yield market.  But valuations by themselves are not a systemic problem.  Solvency and mass layoffs, defaults, would be something that certainly worries me and should worry everyone.

                              And here, I think the fiscal bill that was just past, the CARES Act, takes major steps to avoid a wave of defaults coming from high-yield companies caused just by that primary market being shut.  And as of this bill, everything you said would make me a bit more worried as well.  But the bill includes a provision specifically for midsize companies of 500 to 10,000 employees that they can essentially get 2 percent loans to way below market rates for those companies and it is even below what an IG issuer would expect in the market.

                              Half the high-yield market should qualify and this should both help companies whether an investor striking high-yield and maybe even keep that from happening in the first place since investors will know that companies are able to get access to this financing.

Jeff Meli:              well, Brad, those 2 percent loans that you're talking about come with some major strings attached.  So for example, companies that get those loans have to commit to keeping their employment at 90 percent of their pre-virus levels.

                              Second, they have to agree to forgo buybacks and dividends while the loan is outstanding plus an additional 12 months.  And third, they have a bunch of provisions around collective bargaining, executive compensation, that companies might find constraining.  So, I'm not so sure that companies are actually going to be willing to accept those terms and tap into those loans.

Brad Rogoff:         Some of those are probably a bit less imposing than they seem, Jeff.  So, who would really buyback stocks with the government loan on the books?  And buybacks, dividends, those are not as important to high-yield companies.  Certainly, it is something they will do when they have plenty of cash flow.  But in a period of an economic downturn, that's probably not what a high-yield company is doing anyways.

                              And some private equity backed companies, yes, they may think twice, but the restrictions are listed, as you say, a year after repayment.  And so, I think what happens here is we don't see companies line up for this immediately, but they'll be thankful to have it if their backs are up against the door in a few months.

Jeff Meli:              OK.  So, I think maybe a more major critique of relying on this program, which is that although these 2 percent loans may require an interest level that's below the market rate, it's still debt on the balance sheet of companies that have almost surely had their equity value take a huge hit due to the economic disruption we're going through.

                              So, adding debt to those balance sheets may be unmanageable at any interest rate, and that means that you would still get defaults. So, whether they access those loans are not, these companies that are challenged would go – could go out of business.

                              And what about companies that have more than 10,000 employees?  So, these loans only apply up to 10,000 employees.  But for example, all those fallen angels were talking about earlier, many of those are huge companies that have way more than 10,000 employees.  They're going to be out of scope for all of these federal programs.

Brad Rogoff:         Well, I think your major critique is probably your best critique here.  There's definitely a risk of the CARES Act, only delays default is first actually preventing them.  If so, hopefully, they come a time when the economy can absorb them better.  I mean it's still somewhat of a success and that it would have stopped credit stresses from accentuating other economic stresses.

                              Where I really don't have a great response is the fallen angel retailer or the high-yield movie theater company that employs well more than 10,000 people.  And there are provisions that should allow them to get loans in this bill, but those are likely to be secured if their capacity to do that and have much less favorable rates in the 2 percent that we're alluding to.

                              They probably can't afford the extra debt once again like you said and really need the type of loan forgiveness or grants to pay employees at the airline industry, for example, has received.  Perhaps this will be what comes in Phase 4 of the stimulus bill though.

Jeff Meli:              If that happens, we'll have to discuss that again on the future episode.  So, for deeper analysis, clients can read our latest global outlook entitled, Batting Down the Hatches, where we discussed the economic implications of COVID-19, plus a new report from our credit research group called Congress Cares About Corporates Too, discussing the impact of the CARES Act on the corporate market.