New Paradigm in Credit Markets and the Real Cost of Excess Liquidity: Tighter Spreads, Higher Defaults and Lower Recoveries

The year 2020 thus far has been very unusual, to say the least. And, for the most part, not in a good way. One of the most striking discrepancies is the disconnect of the financial markets and the economy. Looking at broad market indices, both, equities and credit, are trading not far off the recent highs and tights projecting much more optimistic picture than the coming economic performance may indicate. The obvious force propping up risky assets has been the extraordinary central bank intervention providing limitless liquidity and buying assets across the board. 

2020 YTD FED B/S, GDPNow Index, S&P 500, LQD IG Corporate Bond ETF. Source: Bloomberg.

The markets have been stimulated and “managed” by the central banks almost non-stop since the last crisis of 2008/2009. Already high at the beginning of this year, the Fed’s balance sheet exploded when they went into overdrive after the COVID-19 economic shocks, as depicted in the graph above. 

Strange Magic

This created a whole new reality, an alternative world, in which the traditional rules of financial physics seem to have been suspended. In this fantastic new world, we have been experiencing all kinds of financial miracles, large and small.

For example, the government could shut down the entire economy, print unprecedented amounts of money and liberally spread it around, all while purchasing power of the USD seemed intact. At least for now. An MMT dry run?

In another instance, a barely profitable and oftentimes struggling niche car company, with only 0.8 % share of the global automobile production, can become the single most valuable automobile manufacturer in the world, and boast a market cap of $278 bln. Its stock almost quadrupled in a matter of months, while the rest of the equity market has been struggling to break even for the year. 

Another example could be a bankrupt car rental company, shares of which experienced such “investor” demand post-bankruptcy filing, that the market price jumped from $0.85 per share to almost $6 in a week. After this massive move, in an almost-certainly worthless equity, the company seriously considered issuing more shares to raise money. They actually got the bankruptcy court’s permission but also some pushback from the SEC.

This magic not only permeated equities but is also present in credit. While credit risk and conditions are rapidly deteriorating, the demand for corporate credit has soared to historical levels. At any other time it would be counter-intuitive, but in the current market reality, investors can’t get enough of credit risk, helping corporates issue record amounts of new bonds.

Normally companies want to reduce debt in the face of increased insolvency risk, but today the corporates are doing exactly the opposite by increasing debt. Some say they are being opportunistic and securing funding while the markets allow it but, on the flip side, investors don’t seem to be demanding special compensation for the elevated risks and just continue to pile on.

Comparison of the YTD issuance over the past 20 years, as depicted annually in the graph below, shows this year’s issuance breaking record across the IG and HY universe.

It appears the general belief is that as long as the central banks are flooding the markets with liquidity, asset prices can only go up, while yields and spreads can only go down. They certainly have, especially since March 23rd:

CSI BBB Spread, S&P 500, Source: Bloomberg.

But to some, with markets seemingly disconnected from the economic reality, this looks like too good of a deal to last. Many of us intuitively understand that there is a cost to it – a price to pay – even though we don’t quite understand where, when, and how.

Two Trends Under the Surface

Lately, however, we have been getting hints of the costs in credit markets hiding under the cover of rallying spreads. While the generic credit spread compression may indicate an improvement in credit risk, under the surface there are two simultaneous trends which point to increased losses going forward. There is empirical evidence for both, which I discuss later in this note:

1)     Increasing Defaults

2)     Falling Recoveries

Considering that these two trends are taking place at the same time, investors should be troubled.

Just think of a hypothetical $100 mm portfolio of credit comprised of 100 bond positions initially worth $1 mm each. In a benign credit environment, a typical default rate would be around 2% or two names for this portfolio. With these two defaults experiencing 50% recovery (or 50% Loss-Given-Default (LGD =1-Recovery)), the total default loss taken in this portfolio under these circumstances would be $1 mm or 1%.

However, if the default rate jumps up to 8% while the recovery falls to 10%, for example, the total default loss taken in this portfolio and under these conditions would equal $7.2 mm ($100 mm * 8% * (1- 10%)), or more than seven times the loss in our benign environment example.

It is a simplistic and arbitrary example, but it conveys the power of both of these trends.

The obvious question investors should ask themselves is: how much wider should credit spreads be to compensate for this new level of risk? It may eventually come to that, but for now the generic credit spreads are on a tightening trajectory instead.

Increasing Defaults

We have been coasting in a benign credit environment, with mostly friendly central bank activity, for about 10 years. We have become accustomed to the ever-present “Fed put”, a safety bid, and allowed ourselves to think that cheap liquidity solves insolvency risk (a worthy subject of a separate note). And thus, we refinanced and extended corporate lives for many companies, which would have died of natural causes absent the liquidity. This state of things would perhaps still be the case had it not been for the abrupt shock of the COVID-19 economic shutdown. This event greatly accelerated the turn of the credit cycle, and despite massive additional liquidity from the Fed, it changed the capital allocation regime to be more restrictive than before. As a result, hopeless companies or the marginal ones which could not withstand the shutdown, have been denied liquidity, with many being forced into bankruptcy.

In reality, for a default to take place, two conditions need to be met: 1) internal company cashflow generation has to be insufficient to service debt, and 2) access to refinancing must be cut off. Many corporates met the first condition over the past several years, but there was plenty of refinancing capacity, hence the second condition was rarely met. That changed with the recent economic shutdowns which greatly reduced indiscriminate refinancing.

As a result, the number of defaults in corporate credit so far in 2020 already exceeds that for all of 2019. One can argue that the record debt issuance has had the effect of postponing some defaults by extending maturities. But this only suggests that, without the robust debt demand and debt issuance, the default picture would have been even worse. 

This Bloomberg compiled data shows 114 corporates filing for bankruptcy protection YTD with a total of $143 bn of assets at the time of filing.

Most filings came from mid-size companies and small business. However, eight largest filers represent three quarters of all the assets value (about $107 bn): Hertz Corporation, Latam Airlines, Frontier Communications, Chesapeake Energy, J.C. Penney, Whiting Petroleum, Avianca Holdings and Diamond Offshore.

The most impacted sectors were Travel-Lodging-Leisure, followed by Energy, Retail-Restaurants, TMT and others. 

Source: Bloomberg

Falling Recoveries

While the number of defaults is increasing, there is empirical evidence that recoveries are simultaneously falling to historic lows. Measured by CDS auction results and the trading prices of defaulted paper, these levels suggest that LGDs (Loss-Given-Default) in the near future will be higher than historical averages.

This is still a fresh trend but certainly an observable one. There are several reasons for low recoveries (high LGDs) taking place. These outcomes can be traced back to prolonged excess liquidity allowing companies in secular decline (newspapers, retail, energy) to continuously borrow. With many pledging assets to the upper parts of the capital structure over time and leaving very little value to recover for the senior unsecured lenders.

Also, the high numbers of defaults in various industries points to lower recoveries from the asset liquidations. For example, if one Airline goes out of business, then the competitors can buy the planes and equipment at normal market prices and move on. But if half of all airlines go out of business, chances are the asset liquidations will yield far lower prices for the same equipment. A function of increased supply and diminished demand.

Today, CDS auctions are a good place to find early indications of recovery trends. CDS auction results are not the final recoveries, but they do reflect market expectations of final recoveries in the context of the appetite for defaulted assets at the time of the auction. In other words, CDS auction results are a good predictor of final recoveries.

The present emerging trend is clearly visible when viewed in historical context for multiple series of HY CDX indices over the last 15 years or so. Even though CDX HY S34 (the current on-the-run index) is still new and matures on Jun 20, 2025 it has already experienced six defaults as of mid-June which attracted less than 10% average recovery in CDS auctions. 

Overall YTD in 2020 we are observing record low CDS auctions results. This year’s average auction recovery is 9.48% compared to historical average of about 40% and 25% for the IG and HY universe respectively. Of the eight corporate-credit CDS auctions, only two recovered close to historical averages while the lowest one recovering only 0.125%. 

Conclusion

Implications of these two trends should be very significant for credit investors.

If the low recoveries become a new normal going forward, then the future LGDs will be higher than historical. Higher LGDs, together with increased number of defaults, point to higher than historical cumulative default losses. These higher future losses are the part of the cost of the excess liquidity stretching the lives of non-viable companies as well as result of collateral migration up from the senior unsecured part of the capital structure. Are investors recognizing these trends yet? Hard to tell. While it is still early on this side of the credit cycle peak, I argue that investors should not ignore these signs. If I am right, then investors are not getting compensated for this new level of risk. Excess liquidity can accelerate the chase for yield, compress spreads, and even elongate high default periods. But it can’t meaningfully reduce the insolvency risk and it could help push recoveries lower going forward. I hate to spoil the magical party, but there is no free lunch. Really.