In recent weeks, the global outbreak of COVID-19 has sent financial markets into freefall. The corporate bond market was not spared in the sell-off as investors sought safety in assets such as sovereign debt and cash. Contrary to 2008, when Credit Rating Agencies (CRAs) were perceived to have led investors astray with the ratings that they issued prior to the crisis, this time around, given that the virus outbreak is essentially a black swan event, investors can’t point their fingers at CRAs.
But rather, rating downgrades and the expected increase in bankruptcies, especially within the high yield segment, are currently at the top of investors’ minds.
The business model of credit ratings can give rise to scepticism since the corporations that they rate pay for their own rating. Therefore, it is not surprising that in times of great uncertainty, the debate surrounding bias in the assignment of credit ratings has reared its head once again as it did during the financial crisis of 2008.
However, while the debate continues, of more importance at present is the review of credit ratings by CRAs. The credit ratings that were issued prior to the virus outbreak should come into question given the current economic situation as businesses that are directly or indirectly impacted will experience a severe downturn in their business operations.
CRAs have recently begun to review credit ratings as March saw the fastest pace of downgrades on record since 2002 with more issuers expected to have their credit rating revised downwards in the coming weeks and months. Victims of recently downgraded ratings from investment grade include Ford Motor Company, Kraft Heinz and Occidental Petroleum.
Since the fixed income market is essentially classified in two broad categories, i.e. investment grade and high yield, the issuers that stand to suffer the most from a potential downgrade are those at the lower end of the investment grade space. That is, those securities and issuers whose credit rating lies within the BBB space but, more particularly, those rated BBB and BBB-.
The duration and impact of COVID-19 is still uncertain as governments seek to limit the impact on businesses
The risk of a downgrade for such issuers to sub-investment grade is a notable increase in borrowing costs as high-yield bond yields generally trade at a significant premium over investment grade bonds; while investors will suffer from the corresponding loss in market value as the yield of the underlying bond increases.
In recent weeks, the investment grade space has been provided with added support as both the European Central Bank (ECB) and the Federal Reserve (Fed) have launched bond-buying programmes targeting investment grade corporate debt.
The ECB launched the €750 billion Pandemic Emergency Purchase Programme, which will increase the range of the Corporate Sector Purchase Programme, while the Fed launched the Secondary Market Corporate Credit Facility with an initial investment of $10 billion.
Therefore, through these bond-buying programmes, the incentive for issuers to remain within the investment grade space is heightened as such programmes will provide support to investment grade fixed income securities.
While the materialisation and risk of credit events (such as the failure to meet interest payments or bankruptcy) is present within the investment grade market, this risk is more pronounced within the high- yield space. High-yield issuers, i.e. issuers with a credit rating of BB+ and lower, tend to have a weaker financial position when compared to investment grade issuers.
High-yield rated companies face a slightly different reality when compared to their investment grade counterparts as while each will face pressures on profit margins and the generation of cashflow, the stark difference with high-yield issuers is the access to capital markets to raise financing in times when liquidity is paramount to survive the duration of the current economic downturn.
In conclusion, the duration and impact of COVID-19 is still uncertain as governments seek to flatten the curve and limit the impact on businesses. However, what is certain is that the effect of the pandemic is global and has affected the majority of businesses negatively. Therefore, selection and quality should be a theme in every investor’s portfolio.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.
Simon Gauci Borda, Junior research analyst, Curmi and Partners Ltd