In Credit, A Swan Song

“Way” back on March 6, I flagged “cracks” in the credit market amid worsening risk sentiment and an increasingly dour outlook for the global economy thanks to various travel restrictions and containment efforts associated with the fight against COVID-19.

I hesitate to use the phrase “I flagged”. That suggests I possessed some special foresight or was otherwise more prescient than the next guy. The reality is, anyone with common sense and a pulse has been concerned about credit for at least two months for one very simply reason: The US corporate sector is over-leveraged and the economic fallout from the virus battle is set to finally put an end to the longest expansion in US history.

When the cycle turns, and everyone is over-leveraged, you get downgrades and credit events.

This time, the situation is exacerbated by, among other things, a massive disconnect between the outstanding pile of corporate debt and dealers’ capacity to warehouse it in a pinch, the concentration of BBB debt as a percentage of total IG outstanding and the proliferation of credit ETFs which are vulnerable due to the inherent mismatch between the intraday liquidity they promise to investors and the underlying assets, which are getting more illiquid by the week.

Throw in an oil shock for the ages and a frozen commercial paper market (which forces corporates to tap credit lines and take other steps that make for awful-sounding headlines) and you’ve got a recipe for a meltdown.

Around 72 hours after the above-linked post was written, the onset of an oil price war between the Saudis and the Russians conspired with escalating virus fears to catalyze a multi-standard deviation blowout in IG and HY. The ETFs have traded absurdly wide to NAV at various intervals. The IG ETF is in free fall – I’m not sure how else to describe it.

On Thursday, a few brave corporates endeavored to dip their toes into the primary market, but things are very, very dicey, obligatory attempts to soothe frayed nerves notwithstanding.

“Liquidity for US IG corporates remains sound, at least over the near term, despite current turmoil in short-term CP markets”, Fitch said this week, adding that “most companies have sufficient cash, committed revolver capacity and are FCF positive”.

Still, the stress is readily apparent, as is market dysfunction. Bloomberg’s James Crombie described pricing on Thursday’s offerings from Disney and UPS as “bankers licking fingers and waving them in the wind as this violent price discovery process extends”.

“Corporate bond yield spreads will widen considerably from their already very broad bands if a now ultra-high VIX does not plunge by more than 40 points from its recent 69 points”, Moody’s warned on Thursday. “When the VIX averaged 58.7 points during 2008’s final quarter, the accompanying averages were 545 basis points for Moody’s Analytics’ long-term Baa industrial company bond yield spread and 1,700 bp for a composite high-yield bond spread”.

On Thursday evening, Lipper said investors yanked $35.6 billion from US IG funds in the week through Wednesday. I mentioned that earlier, but I want to emphasize it again, because the previous record weekly outflow was set just last week, and it was a relatively “paltry” $7.3 billion.

In other words, this week’s outflows from US IG funds were nearly five times larger than the previous record outflow which came just one week prior.

“Credit market liquidity is impaired. A retail exit is our next fear”, UBS’s Stephen Caprio wrote Wednesday. He cited lackluster liquidity in the secondary market as a factor in exacerbating spread widening, and pointed to wide discounts to NAV in the ETFs. For example:


Caprio also cited widening bid-asks as evidence of illiquidity in the underlying bonds. What does one do when that’s the case? Well, one taps the ETFs for liquidity, that’s what. 

“A larger fear is if retail fund outflows commence, given promises of daily liquidity upon redemptions”, UBS wrote.

This was always the worry, folks. But no one ever took it seriously.


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4 thoughts on “In Credit, A Swan Song

  1. What we have here is a run on the bank- it is still going on. Yesterday afternoon it hit muncipal bonds. ETFs are not the culprit, but of course the structure is probably ill suited for corporate high yield and bank loans as you alude to in your article. Not so sure about investment grade bonds, although the concentration of vulnerable BBB in the space is concerning. Remember there is a liquidity mismatch for open end mutual funds as well as ETFs. The run just happens a little more slowly- but in a market like this you will get runs on open end mutual funds as well. The Fed has opened the spigots and fiscal stimulus is coming so I actually think stocks may be trying to find a bottom here. But there are still landmines out there- yesterday afternoon it was the municipal bond markets turn.

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