Jeff Meli: Welcome to this episode of the Flip Side. My name is Jeff Meli, I'm the Global Head of Research at Barclays and I'm joined today by Brad Rogoff, our Global Head of Credit Research. Thanks for joining me Brad.
Brad Rogoff: And thanks for having me back Jeff.
Jeff Meli: Today we're going to revisit a topic that we last discussed in episode 20, how seriously to signs of strains in the credit markets. So, since we last spoke, Brad, there have been a number of developments regarding government support for the credit markets, some positive and some less so.
Brad Rogoff: Look, you and I can argue whether they're positive, negative, regardless of any of those developments, the price action's been only one way in credit, and that's higher since we last spoke. We've seen a massive rally in credit.
Jeff Meli: Yes, and I think that rally is overdone and it's too early to give the all clear sign. I think there are some big holes in the government's support for credit markets, particularly with regards to the high yield market.
And I think some of those holes in the support may be intentional, but they are not reflected in the recent price action that you just spoke about. I think we might be in for another reckoning once this euphoria recedes.
Brad Rogoff: Look Jeff, on the whole, I think I'm definitely more positive than you are on the recent developments. It's true, some of the details were less encouraging that we expected, but others, I think I would argue they were more so.
And whether justified or not, I think the recent gains in the high yield market, they can become self-reinforcing, if companies can have access to financing because rates have lowered as the market rally.
Jeff Meli: All right, last time we spoke Brad, we talked about three challenges facing the credit markets. Pressures in the front end of the market, the risk posed by a material rise in downgrades from investment grade into high yield, so call it fallen angels, and the possibly that companies that started this crisis rated in the high yield category will be left out from the various forms of government support.
I'd like to go through each of these, and maybe the place to start is with the primary and secondary corporate credit facilities, the so-called PMCCF and SMCCF. These are facilities that were started by the U.S. Treasury and the Federal Reserve to try to support the front end of credit markets.
Basically, they're seeded with capital that's provided by Treasury and the Fed takes that capital and leverages it to purchase short-dated investment grade bonds either directly from companies, that's in the primary facility, or in the open market, that's in the secondary facility.
They're both intended to try to alleviate the pressures in the front end by absorbing some of that debt, particularly from companies that we all think are viable long-term enterprises, but are faced with short-term financing challenges posed by COVID-19.
Brad Rogoff: And as we talked about last time, Jeff, the front end is really the life blood for a lot of these large corporates and it can be driven by confidence as much as fundamentals if you need to keep rolling that debt.
Jeff Meli: Well, one detail that I think got a lot of attention from investors about these programs was the inclusion of ETFs and the list of eligible securities that they could purchase, particularly high yield ETFs.
The high yield seemed to rally substantially on the back of that news, but that seems to me like it's a red herring. So, the ETF inclusion is not actually going to lead to a material amount of high yield purchases in these facilities as far as I can tell.
So, the term sheet states that the preponderance of ETFs should be investment grade if they are even purchased in the first place and because single named corporates are actually preferred.
Even if the Fed were to ignore all of those stipulations and just bough as many high yield ETFs as it could, you're only talking about one percent of the high yield market that's held by ETFs, so it really can't be that substantial support for high yield.
Brad Rogoff: All right Jeff, there I tend to agree with you. Inclusions of ETFs, it isn't really likely that the Fed's going to be buying lots of high yield, all right?
And even though the market is clearly reading a lot more into this than maybe you are or I am, I think the inclusion was more about market functioning, and that was because there was a time, if we go back to the middle of March, when ETFs were trading at substantial discounts to NAVs or their intrinsic value.
Now that’s no longer the case but that was really a sign of the market not functioning properly and the ability to buy them will ensure that that doesn’t happen in the near future. But I actually think you’re focused on the wrong details about the two credit market facilities. You left out a few things, all right?
So first, the sizes were increased. They were initially sized at $100 billion each facility but they have now increased to a total of $750 billion. And based on the amount of short data depth that we expect actually needs to be issued.
I think these programs are going to make a huge difference at the new size. I also suspect that the capacity could be increased if that became necessary although as I just alluded to I don’t think we’ll get to that.
But probably the more important detail to emerge was actually the inclusion of recent fallen angels to be available to be purchased. So we’re worried that assurgent fallen angels driven by COVID-19 would put serious pressure on the high yield market which was already quite strained.
Companies that are downgraded after March 22nd now qualify for this facility. The Federal Reserve will leverage those holdings to a lesser extent. Makes sense, there’s greater risk (inaudible) their high yield today for a reason.
But they’re included nonetheless and that’s the important thing. It was a surprise that this came out with the inclusion of fallen angels. This is not just these fallen angels; it’ll be potential future fallen angels that are included. And I think it takes a lot of pressure of the high yield market.
Jeff Meli: Look, I was surprised by the inclusion of fallen angels too, Brad. But it does appear that the government is inclined to make sure that companies that enter this crisis with conservative financial leverage policies are the ones that actually receive the support and they’re less concerned about the immediate effect of COVID-19 on balance sheets in terms of qualifying for the programs.
But I’m actually worried about -- that these facilities aren’t going to get used. So, for example it’s come out that the Federal Reserve will require companies to self certify that they need a series of criteria in order for their debt to actually qualify for these facilities. These include things like their U.S. (inaudible) which is relatively easy plus they haven’t taken aid from other aspects of the CARES Act.
So, you’re only supposed to take aid from one program. You’re not really supposed to double dip as a company. There’s conflicts of interest with official figures, etc. that companies have to certify to. Those are imposing constraints on companies. They may not actually take advantage of this if these burdens are too high.
Brad Rogoff: Look, there is a little bit more here, Jeff, in terms of yes, you have to go through some hoops to get access to this. But honestly I think these programs can be effective even if they’re not used to a great extent. That’s particularly true when we’re talking about something like the frontend.
Really the goal there is to restore confidence and reduce liquidity risk just to allow capital markets to function. I think the best evidence of this has happened already. You have credit curves that have steepened, so that’s another way of basically saying frontend (inaudible) or even to a greater extent than the rest of the market as we’ve seen broad stabilization with respect to credit markets.
And actually on fallen angels take Ford as an example. A recent fallen angel after March 22nd and they actually just did the largest new issue ever in the high yield market last week and the Fed brought none of it. So these programs are working before you’re even buying a single bond.
Jeff Meli: Let’s shift to the programs that have been less supportive.
Brad Rogoff: All right. Presumably you’re talking about the Main Street new loan facility and the Main Street expanded loan facility there.
Jeff Meli: Yes, I am. And there were two details about these programs that I thought left me wanting in terms of the level of support they would provide the economy and markets. First was the pricing of the loans that these facilities would issue. So last time we spoke about a 2 percent interest which is what we had sort of thought that the interest would be associated with these loans.
The actual interest could be materially higher than that. It’s actually (inaudible) which is an overnight financing rate plus somewhere between 2.5 and 4 percent. That’s for the expanded facility. That’s what we think the biggest corporates would use. So that’s materially above the 2 percent figure that we had been tossing around earlier.
Brad Rogoff: I grant you that that’s higher, but when you think about the corporates that are going to actually, potentially use this; that’s still a lot lower financing than they can get anywhere out there on the market.
So I don’t think that’s going to be the point that stop’s them from accessing these facilities.
Jeff Malley: OK, but the other constraint Brad, I think is more severe; and that’s the size of the loans that are being offered. So the new loan facility offers loans up to $25 million and the expanded facility up to $150 million dollars.
Now these are supposedly intended for companies with between 500 and 10,000 employees and up to $20.5 billion of annual revenue.
So these limitations on size could be fine for companies at the lower end of those spectrum, but there’s no way they are sufficient for companies at the upper end of that size range.
And I think that’s where actually the job losses could end up being concentrated if we were to see a wave of bankruptcies. A second constraint is that there are limitations on the leverage that a company can have to qualify for these programs.
It’s four times for the new loan facility and six times leverage for the expanded facility. That’s after accounting for things like (undrawn) revolvers, et cetera.
And our best guess is that less than half of the high yield market would end up qualifying for either of these facilities; probably even less than the lesser percentage of the loan universe actually.
To me it indicates that this facility is sort of designed to miss; so on the surface yes, it does something for high yield, quote un-quote, helps the market, it’s included in these programs. But I’m not sure it’s actually intended to provide meaningful support to these companies.
Brad Rogoff: Yes, this one I think I have to actually be in agreement with you Jeff, you actually left out some other constraints. There’s one which is that these aren’t fully government backed loans or fully government guaranteed loans, actually 5 percent of the risk has to be held by banks.
I don’t think that actually prevents much lending, because banks understand that they need to be lending in this time.
But the other one – and they have a pretty big impact in terms of another constraint – and that’s really what caught the attention of most credit investors; and that’s that the expanded facilities actually secured debt, not un-secured debt as was advertised in the Care’s Act.
So the company needs to have the ability to incur the debt based on their existing covenants and whatever debt they have outstanding, or we need to actually seek an amendment before they could even come and ask for this money.
So I think you’re right, take-up on these facilities is going to leave out a lot of the current high yield universe.
Jeff Malley: Yes and that’s really under-pinning my belief that the massive reality we’ve seen in credit in general, but particularly some of the biggest returns ever in high yield, the biggest in-flows, that that’s over done.
Brad Rogoff: All right, I think you have to be careful there though, not to paint the whole market with one brush. I’m pretty positive actually on the investment grade market right now, since it benefits from the facilities we spoke about earlier.
And this should actually benefit high yield indirectly; particularly the higher quality BB companies. So first with respect to investment grade; if it’s bought by the fed, then those who used to buy investment grade, they should start to have to buy high yield logically.
This is the crowding out effect that’s been a big part of QE and what we’ve seen over the last several years. It’s benefited the investment grade market actually, in the past when the fed was buying treasuries and mortgages and I think logic would dictate that now it should help out on the high yield side.
And in fact we’ve seen for several years in Europe the ECB and their asset purchase program has included investment grade corporates already. And this has definitely led to traditional investment grade buyers replacing investment grade corporates because the ECB was buying them.
And they’ve been buying high yield instead, it’s particularly BB’s; and that’s caused high yield spreads to tighten in Europe. Second; there’s a real benefit from the fed buying fallen angels, as I’ve said before. It should significantly limit the pressure on existing BB’s, which is something we had all feared.
So to me that’s pretty material; but your point about the Main Street facilities does leave me less positive on the lower quality parts of high yield and I think you really have to draw a line between those two.
Let’s be clear though, this is a down turn and that’s pretty typical in a down turn. The most levered companies should be the ones that have the highest default rates and we’re expecting that to be the case in this crisis.
So my point really here, the government support is available for less levered companies – really in several forms, right?
And we will typical see a default rate say 10 percent for the high yield universe in a downturn. I think we are going to see something similar in this downturn, but not dramatically more; and that it would be dramatically more if we didn’t have the government coming in with these programs.
Jeff Meli: I think it’s interesting, Brad, that the fed is being quite clear about where the lines are in terms of receiving official support. There seems to be a lot of skepticism about supporting companies that entered this crisis with too much leverage.
And it’s actually – it’s kind of been keeping with other actions that the fed has taken – so I’m thinking back five years ago to the leverage lending guidelines -- where the Federal Reserve designed these guidelines to stop banks from lending to companies that was over six times leveraged. (Oh), it turned out that the fed was not exactly following the right protocols when they issued those guidelines.
So they were forced to make them somewhat less stringent. But I think that they were a (harbinger) of this underlining suspicion of companies that use financial engineering to deduce their returns. And I think that may have found its way into some of the programs that we are talking about today.
Brad Rogoff: Look that six times level felt a little too familiar to someone who spent a lot of time thinking about the leverage lending guidelines and how the feds have been thinking about that historically when I saw it in the term sheet.
It’s also not lost on me the leverage loan and (CLO markets) they’ve really received the most criticism by far throughout this cycle from aggressive lending practices during their recovering and they’re receiving little than no support honestly.
That leaves private equity backed companies in difficult place is they disproportionately went to the bank loan market and not to the high yield bond market actually to finance acquisitions over the last decade. These companies do employ a lot of people though. So it’s not without consequences that they’re being left out.
Jeff Meli: Yes, you do have to draw a line in the sand someplace and as we talked about earlier, the fed is using somewhat less leverage when they lend to high yield companies but they’re still using leverage.
And if you lend with leverage to companies that are already close to the line in terms of how much leverage they’re employing you can actually create big losses. And obviously, the Federal Reserve has to avoid to the greatest extent possible – actually taking losses on their portfolio.
And I think there’s also probably some underlining concern that they want to influence the way companies think about their leverage policies going forward.
So if they started off – even before this COVID crisis – suspicious of leverage levels that were over six times or generically too highly levered then these new programs could be a way of trying to get companies to think twice before they get to those levered – leverage levels in the first place. They might be thinking that if there was another crisis official support won’t be there for them anymore.
Brad Rogoff: Look, it’s really hard to argue with the math that you sort of went through there. But one thing to remember here is they would be coming in – by they I mean the Federal Reserve – as secured debt in the main street program – the expanded program at least – which does provide downside protection for the Federal Reserve.
Also, essentially what it’s doing by adding more debt to a company – if you think about their total enterprise value – it is taking value away from the equity and perhaps that’s owned by private equity.
So, look, I don’t think there is a clear solution here. But, maybe there’s suppose to have a separate program for highly levered companies that also provides the fed with some upside in form of maybe an equity state that they’re actually taking as well. Which is similar to what we’ve seen in some of the troubled industries that got direct access to the CARES Act.
Jeff Meli: Right, and I guess if we see some of those programs that’ll be (fottered) for another episode of The Flip Side. Thanks for joining us. Clients can access our latest research about the effects of COVID-19 on the markets and economies at #virus available on Barclays Live.