How is Coronavirus Affecting the Money and Capital Market ?
Updated: Apr 4, 2020
The crisis the world is currently witnessing will sooner or later come to an end, this is a certainty. However, we already notice how bad the economic damage is because of the draconian measures worldwide governments are forced to take to stem the spread of the virus. The economic activity has indeed fallen even deeper than it was during the 2008 global financial crisis. In response, policymakers from all the world have decided to take unprecedented actions to mitigate the impact of this economic scourge using both fiscal and monetary policies. Consequently, this situation has significantly affected capital and money market urging companies to find new financing solutions.
Central Banks actions
Let’s first recall the three main actions undertaken by Central Banks in order to reduce the slowing economy consequences. They first cut interest rates to ease borrowings and helping people to keep consuming. For instance, the FED has steeply lowered its interest rates down to 0.25%.
Money have also been injected into financial markets for banks to keep lending and ensuring the money supply in the real economy.
Moreover, they’ve put a lot of money on the line to buy assets such as corporate and government bonds. FED has committed to buy unlimited amounts of government bonds which has reassured investors. For its part, the ECB has planned to buy an extra 750bn of euros bonds this year.
These measures give investors hope to see the economic shock soothed and a likely start of recovery at the end of the year. This explains the FTSE All World index has seen an increase of 14% last week after more than a month-non-stop tumbling . However, this bounce sounds maybe too optimistic to some investors. Indeed, if the amount of infected people increases, job losses and loan defaults keep rising at the current pace and that the healthcare system remains overwhelmed, their optimism risks to shift to the pessimism they used to know at the beginning of march.
Impact on the Leveraged Loans and CLO’s market
Companies whose creditworthiness is low-rated often use leveraged loans to finance. These are then securitised into Collateralized Loan Obligation*. In recent years, the issuances of these kind of loans have been gaining popularity among investors keen to take greater risks and make higher returns. However, doubts that highly indebted companies wouldn’t withstand the shock economy is currently undergoing have entailed a plummet of those assets value. Indeed, with the spread of COVID-19, investors expect to see an increasing number of companies to default on their loans and especially in the energy and air transport. “The impact of the crisis in the CLO market has been a disaster” according to the CEO of Gapstow Capital Partners, Chris Acito. Let's note that nearly 10% of the CLO’s assets have been downgraded since the beginning of march. Fitch Ratings has also raised the default rate forecast for leveraged loans to 8%. As the quality of CLOs keeps deteriorating, the main owners of those assets - banks, insurance companies and asset managers - will now need to increase their regulatory capital in order to limit losses.
Difficulties to raise funds in the commercial paper** market
Despite the FED’s efforts to stimulate the weakening economy, financing costs in the commercial paper market have nevertheless soared since the beginning of the outbreak. Blue-chips*** US companies have even seen a $1,1tn funding source for daily liquidity needs remaining frozen prompting them to look for alternatives to finance.
However, FED has announced its will to foster the issuance of commercial paper with a programme - which will only be applied at the end of April - that will only support companies rated above A1(S&P Global), F1 (Fitch) and M1 (Moody’s). The other lower-quality companies will be secluded and therefore see their borrowing costs remaining high.
As the commercial paper market and the traditional capital market seize up, companies are now turning to bond market and bank credit lines to finance.
In march, $124bn have been drawn from credit lines by more than 130 companies in Europe and Americas. Given the large number of trips cancellations due to the pandemic, the travel-related companies such as Hilton Worldwide were the firsts to tap credit lines.
Alongside, the corporate bond issuance has significantly soared last week after the FED’s decision to buy unlimited amount of those securities.
Finally, the resort to financial credit lines emphasizes here the undeniable role of banks as one of the only alternative to ensure most of the companies survival in such a severe situation. And as Sascha Steffen - professor at the Frankfurt School of Finance - quoted : “This reflects the fact that banks remain the main source of liquidity insurance for US companies”. However, for many companies and multinationals already debt-ridden, Moody’s warns the risk of seeing a rise of defaults especially if the economic downturn extends into the second half of year. Indeed, the global default rate is expected to reach 18,3% in this latter case exceeding that of 2008 financial crisis.
Édouard Wauquier - Head of Corporate Finance
*Security consisting of a group of risky loans - often corporate loans - gathered by maturity and default-risk. Banks sell loans they own to a CLO manager in charge of allocating them into branches according to their degree of risks before going into the capital market. Investors buying in the lowest tranche have the biggest return expectancy but take the highest risks.
** Short-term ( maturity doesn’t exceed 270 days ) debt security.
*** Blue-chips are large (market value exceeding several billions of dollars) and stable corporations producing well-known products while being leader in their business-segment. They often see their stocks following the general stock market.