Don’t Fear The Zombies.

“As it became clear the pandemic would significantly disrupt economies across the world, markets for longer-term debt also faced strains”, Jerome Powell explained, in prepared remarks to the Senate Banking, Housing, and Urban Affairs committee delivered Tuesday, via video conference.

He proceeded to further detail the rather straightforward rationale behind some of the Fed’s emergency lending facilities rolled out over the last two months.

“The cost of borrowing rose sharply for those issuing corporate bonds, municipal debt, and asset-backed securities backed by consumer and small business loans”, Powell said, before dumbing it down a bit for anyone who might still be confused as to what happens when short-, medium- and long-term funding markets freeze up in a thoroughly financialized economy.

To wit, from Powell:

Effectively, creditworthy households, businesses, and state and local governments were unable to borrow at reasonable prices, which would have further reduced economic activity. In addition, small and medium-sized businesses that traditionally rely on bank lending faced large increases in their funding needs as they struggled with possible closure or substantially curtailed revenues. The Federal Reserve also took action with the Treasury Department under section 13(3) to support the credit needs of large employers through the Primary Market Corporate Credit Facility and the Secondary Market Corporate Credit Facility. These facilities primarily purchase bonds issued by U.S. companies that were investment grade on March 22, 2020. By purchasing these bonds, the Federal Reserve is able to lower the borrowing costs for investment-grade companies and thus facilitate economic activity. The Federal Reserve is also preparing to launch the Main Street Lending Program, which is designed to provide loans to small and medium-sized businesses that were in good financial standing before the pandemic. 

To be sure, most people with a working understanding of the system’s plumbing (as it were) realize it was necessary to dust off the GFC-era commercial paper facility and also to take steps to alleviate stress in prime money market funds, and ensure the cost of dollar funding to the world didn’t become unduly prohibitive. Not much about those facilities is particularly controversial.

However, some of the other programs have been met with derision. The corporate credit facilities are the most obvious example. I’ve discussed this at length in these pages across dozens of posts.

There are two main lines of criticism, one of which has more validity than the other. First, some critics warn taxpayers could suffer in the event the the first-loss buffer provided by Treasury for the two corporate credit facilities is eroded, and the special purpose vehicles have to be recapitalized. That’s possible, but it’s not like anybody is going to send you a bill. Any extra Treasury funding for these facilities would likely be included in an additional package of spending measures passed by Congress for virus relief, and would be “paid for” via more bond issuance. Let’s face it, you’re not going to notice that. Especially not in the context of some much larger relief bill. Your “grandchildren” aren’t going to notice it either. Besides, there is no guarantee losses will be incurred in the first place, and the very fact that these facilities exist acts as insurance against that outcome.

The second line of criticism is potentially more vexing, but I’ve been keen to dismiss it. The “moral hazard” argument has become a rallying cry for many high profile market luminaries (e.g., Howard Marks) and also for some lower-rung names.

Guggenheim’s Scott Minerd toned down the hyperbole in his latest “outlook” piece in favor of a pragmatic approach to the situation which, I must say, makes for much better reading than some of his other recent musings. I imagine investors are glad to know he’s back to focusing on how to make money, as opposed to obsessing over how wrong-headed everyone besides him is. Consider these excerpts from a note Minerd published on May 10:

Many companies, including Boeing, Southwest, and Hyatt Hotels, have likely gained access to financing simply on the strength of the government’s intentions to intervene in credit markets. Successful debt offerings have also been completed by recent fallen angels like Ford and Kraft Heinz, both of which had corporate bonds trading at or near distressed levels only weeks ago. This was a real success for corporate bond issuers, but it was also a success for the Fed.

The Fed [had] yet to buy a single bond in the SMCCF, but the mere announcement of the program has managed to tighten credit spreads dramatically and greatly ease liquidity issues. This reminds me of the period between 1942 and 1951, a period in which the Fed targeted a maximum rate of 2.5 percent on long-term Treasury bonds. Amazingly, the Fed ended up buying only a small amount of Treasury debt during that period. The reason, of course, is that the market perceived that the Fed had given Treasury investors a put. Any time rates began to approach 2.5 percent, investors would step in and start buying because there was very little downside. A similar dynamic is at work right now in the credit markets.

The support on offer to corporate America during this period of economic shutdown risks the creation of a new moral obligation for the U.S. government to keep markets functioning and help companies access credit. This means that corporate borrowers are most likely on the way to becoming something akin to government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac. The difference is that in this cycle, it is not a specific institution that is too big to fail, it is the investment-grade bond market that is too big to fail.

If you’re familiar with Minerd and his often verbose tone (see here, here and here), I’d encourage you to note is that those passages convey the exact same “moral hazard” argument, only more effectively, because instead of waxing hysterical about the circumstances, Scott just matter-of-factly describes the new reality. Kudos to him for the shift in tone.

The crucial point in all of the above is simply that the Fed couldn’t possibly be expected to allow the investment grade primary market to effectively shut down at a time when companies needed cash most. The nature of this crisis is different than that witnessed a decade ago. With consumers literally confined to their homes by government decree, many credit-worthy companies would see their revenues and operating income collapse almost entirely.

It wasn’t clear, during the height of the panic, how long that state of affairs was set to last. When the Fed first announced the corporate credit facilities, Italy and Spain appeared to be on the brink of an almost apocalyptic health crisis. Consider the figure.

Italy was losing between 600 and 900 people per day around the time the Fed stepped in with its most aggressive package of measures in the history of the institution. Spain was in the same situation just days later.

I suppose this goes without saying, but when countries with between 45 and 60 million people are losing between 500 and 1,000 citizens every, single day to a virus, it creates considerable consternation among market participants, who are forced to consider whether the world is on the brink of something straight out of a Hollywood doomsday blockbuster.

How many companies do you imagine would be able to borrow in that environment absent a Fed backstop? The answer is zero. The market would have slammed shut entirely had those virus fatality curves not flattened. At the time the Fed announced the establishment of the corporate credit facilities, they were still upward sloping.

And, no, none of your favorite “name brand” investors would have been willing to provide capital in an environment where the entire country of Italy was busy dying, either. Warren Buffett may well have been “getting calls” in March (as he said earlier this month), but you can believe that if Italy and Spain had kept losing 800 people per day for longer than a month, he’d have stopped answering.

The point is: The idea that “moral hazard” should have played a role in the Fed’s decision calculus in mid- to late-March isn’t just absurd, it’s insane. Corporates were already drawing down revolvers and exhausting credit lines. Once those were tapped out and the primary market slammed shut, it would have been game over.

Instead, thanks to the Fed, it was “game on”. As documented here extensively, March and April ended up being the biggest months for high-grade issuance on record and it wasn’t a bad haul for high yield either.

Remember when September’s then record pace of IG supply seemed impressive? Not so much now.

Somehow, through all of this, we’re still talking about “zombie” dynamics, a discussion that made a whole lot of sense outside of a pandemic scenario. Consider this from a Bloomberg article out Tuesday called “America’s Zombie Companies Are Multiplying and Fueling New Risks”:

As the Fed pulls out all the stops to bolster credit markets, corporate America is gorging on debt.

From Carnival, Marriott, and Delta, to Gap and Avis Budget, many of the companies hardest hit by the coronavirus outbreak have priced billions of dollars of bonds and loans in recent weeks.

Never mind that profits have been wiped out, and that their business operations aren’t viable right now or likely anytime soon. As long as they’re propped up by the Fed, investors are willing to lend.

Yet as expectations of a V-shaped economic recovery vanish rapidly, more and more industry veterans are starting to express concern about these debt dynamics. Some warn that the Fed is putting credit markets on course for a future wave of defaults that makes the current stretch of corporate bankruptcies look timid by comparison.

“Zombie” dynamics is one of my favorite subjects, as long-time readers are well aware. Let’s recap.

The post-crisis monetary policy regime effectively served as a zombie creation lab. “Rather than financial markets efficiently allocating capital to productive, growth-rich companies, investors’ desire to reach for yield amid a low rate world means inefficient, ex-growth firms are able to secure funding and roll-over debt”, BofA’s Barnaby Martin wrote last May, updating his previous work on the walking dead.

“The end result is impressively low default rates, but also a clustering of companies across the market where their long-term existence is highly questionable”, Martin continued. “Easy money creates a lifeline for ‘zombie’ firms to persist”.

The ultimate irony, of course, is that the proliferation of zombies arguably acts as a deflationary force. That is, excessive and prolonged central bank accommodation has paradoxically served to create a disinflationary impulse in some sectors of the economy when otherwise insolvent production is allowed to remain online or hibernate — as opposed to going out of business.

With investors starving for any semblance of yield, markets remain open to companies that would, under normal circumstances, have lost access. Poor balance sheet discipline has been rewarded rather than punished and far from being purged, misallocated capital becomes even more misallocated.

The end result: Zombies. Lots of them. And with them, the very same disinflation that central banks are ostensibly trying to vanquish.

That is an undesirable state of affairs. And the leverage that’s part and parcel of those dynamics made corporates more vulnerable headed into the current crisis.

But clearly (or at least it should be clear), these concerns must be put aside in the interest of avoiding a scenario that nobody really wants to see. Consider the following from Bloomberg’s Laura Cooper:

The Fed’s ammunition may have a long way to go but digging into details of Friday’s FSR shows the potential limits of the Powell-put. A wave of defaults has been staved off by stimulus efforts with a credit crisis averted — albeit artificially. But cracks in the credit market will be tested as earnings declines send interest coverage ratios tumbling. Earnings to interest expenses were in line with historical medians pre-pandemic on account of low interest rates. But with debt ratios of non-financial public firms clocking in at a two-decade high heading into the pandemic, and highly levered firms near record highs, the “sizeable increase” in defaults as a result could challenge the scope of a Fed lifeline. In prepared remarks for Senate testimony, Powell emphasizes the need to purchase corporate bonds at risk of downgrade to lower borrowing costs. But despite its bid to save fallen angels, the Fed warned of widespread downgrades that could generate severe market dislocations. Already $125b of investment grade debt has been downgraded to junk since late February and comes after a near record high 50% of quality credit was in the lowest category before the virus shock. The Fed has shown no signs of turning off stimulus taps for firms to withstand the period of weak earnings. But its commitment to catch fallen angels and stave off defaults indefinitely will be tested as credit pressures build. If its backstop knows no bounds, it could end up with bigger zombie risks on its hands when the health crisis ends. 

It’s true that the Fed could end up staring down more “zombies” after the crisis abates. But, as Cooper alludes to in that short blog post, when revenues and profits plunge by 50% or more due to some wholly unforeseen development, it’s no longer clear what “insolvent” even means.

Is a company that was able to cover its debt service costs many times over as late as February really “insolvent” because the government told all consumers to board themselves up at home to avoid catching a deadly respiratory illness? Maybe. But taken to its logical extreme, that means that in an event where total lockdowns last for more than, say, three months, nearly every company in America that doesn’t generate the majority of its revenue and earnings from online activities (or can’t substitute sales made at physical locations with home deliveries of those same goods or services) will be “insolvent”.

What happens after that? How do you sort that out? Spoiler alert: You can’t.

So, at the end of the day, the conclusion we must all come to, no matter how begrudgingly, is that when faced with the closest thing to a literal, Hollywood zombie apocalypse that any living human has ever witnessed, we shouldn’t fear figurative zombie dynamics in the corporate credit market.

Now, if only Jerome Powell were as adept with witty snark as I am, he could communicate this more forcefully to a world where everyone is a critic.

---