Fear itself

| March 6, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Public response to coronavirus has quickly become far more important to the markets than the illness itself. Although plenty of questions about the virus remain, most available information from seasoned public health officials shows a measurable and likely manageable risk. The arguably unmeasurable and consequently unmanageable risk for now comes from closed schools and businesses outside of China, cancelled travel, signs of falling consumer demand and other economic damage. The drop in rates and the sharp widening of spreads has created immediate risk to any highly leveraged portfolio. Uncertainty about the economy and earnings creates risk over the next few months to leveraged credit. Banks, subject to both rates and credit risk, could tighten credit. This is the stuff likely to drive markets until the course of the virus outside of China becomes clear or until monetary or fiscal policy comes to the rescue.

Increasing clarity on the illness itself

The World Health Organization and others now paint a picture of the epidemic in China in retreat. The number of new cases outside Hubei Province, where the epidemic began, now runs between 10 and 20 a day, and signs of economic activity continue to rebound. Daily tracking by Johns Hopkins (available here) shows the gap between cumulative cases and cumulative recoveries in China rapidly closing.

Outside of China, the spread of the illness is likely still in its early phases. The ultimate course will depend on public and private efforts at prevention, the quality of the health care response, population density and other factors that vary from country to country. If the course of the illness in China is a template for other areas, however, then infections, hospitalizations and fatalities in the US and Europe are likely to keep rising at least into May. The market will likely need to see enough cases after a peak to infer an inflection point. That could leave the market waiting for clarity until June.

In the meantime, WHO and other authorities continue to provide a steady flow of information about the coronavirus (available here) critical to public response. Evidence now suggests the illness spreads more slowly than the flu, that infected persons without symptoms are less contagious than asymptomatic cases of the flu, and that children are less susceptible. The number of infections for each case of coronavirus does seem to be higher than the flu, the incidence of severe or critical infection is higher, and mortality is higher—although mortality depends on quality of health care.

Economic warning signs outside China

Uncertainty about the economic impact of coronavirus arguably is higher for now than uncertainty about the disease. Most government reports reflecting the economic impact will only come out in the weeks and months ahead. The market instead has to rely on announcement from public businesses. US airlines have started canceling domestic and international flights, and at least 43 public companies have issued profit warnings since the end of January specifically citing the coronavirus—at least 14 announcements coming in the last two weeks alone. The pace is only likely to increase.

Risk from rates

The US yield curve has dropped by nearly 100 bp since mid-January and, among other things, stands to trigger the largest wave of mortgage prepayments since at least 2012 (MBS with significant refi incentives jumps to 75%). The speed and magnitude of the move is rare, and a range of leveraged portfolios have had to manage it. That includes selected mortgage servicers, mortgage hedge funds, mortgage REITs, broker/dealers and banks. These portfolios may be in reasonable shape if they used options to hedge the risk of falling rates, but the speed of the movement likely made it difficult to delta-hedge the shortening duration of mortgage positions.

Outside of banks, many of these leveraged portfolios rely on wholesale funding. The providers of those funds have almost certainly started looking at the net equity of these portfolios. That will be especially true for portfolios that hold illiquid or infrequently priced assets. Over at least the next few days, if not longer, the market will have to watch for weak hands and potential forced sales that could further disrupt markets.

Risk from credit

Spreads on investment grade credit have widened by more than 45 bp since mid-January, on high yield credit by more than 165 bp, and the average price of a broadly syndicated leveraged loan has dropped by more than $3.29. The amount of financial leverage in these markets is almost undoubtedly less than in rates and MBS, so risk of significant loss to portfolio equity is much lower. Leveraged credit portfolios will still bear watching.

The bigger risk to credit likely comes from highly leveraged corporate balance sheets. Many of these companies, especially in investment grade ‘BBB’ and leveraged loan ‘B’ names, have relied on a range of adjustments to EBITDA to meet rating agency leverage targets. Those adjustments include cost savings, synergies and other projected gains. The EBITDA targets may become increasingly difficult to reach over the next few months, and earnings shortfalls could trigger covenants that make markets and lenders more nervous. Companies that have good liquidity should still be fine, but not all fall under that umbrella. Investors concerned about downgrades could become sellers.

The position of banks

The sharp drop in rates has also saddled banks with a sharp drop in asset duration and prospective reinvestment of a big part of the balance sheet at lower rates (see Asset-liability impact of the coronavirus rally in debt). Net interest income is almost certainly going to come under pressure, and banks will also likely have an eye on the impact of a slowing economy on their own loan books. Falling income and rising credit concern, even if temporary, could start to tighten credit conditions.

Monetary and fiscal policy

The Fed made its first bold move on March 3 by cutting target fed funds by 50 bp, and the Fed and looks likely to cut another 25 bp on March 18. The distance between the target rate and zero is narrowing. There is a small chance the Fed begins reinvesting MBS principal back into MBS, and an even smaller chance of outright net buying of MBS and Treasury debt. Discussion of whether fed funds could go below zero should heat up, although those chances still seem very small (see A narrow path to negative US rates).

The base case

Despite clear risks, the base case still seems to include a market that turns once the trajectory of coronavirus become clear outside China. The information about the illness so far suggests it can be contained. Once past that inflection point, the magnitude of recovery will likely depend on economic damage to that point. It could take months after inflection to determine that. The market could easily remain volatile through the summer.

* * *

The view in rates

The narrative of contagion has now pushed US rates to record lows. The current 0.76% rate on 10-year Treasury debt implies an average real rate of -0.55% and inflation of 131 bp. Futures now imply policy rates near the zero-bound by August and staying there through 2021. Both the Fed and fundamentals are likely to be different, but global flight to quality is likely to keep rates low until the market gets better information about the course of the coronavirus

The view in spreads

Despite the flight to quality, investment grade and high yield spreads have only widened to levels slightly wider than those last seen in late 2018. MBS spreads should remain under pressure from some of the fastest prepayments since 2012. MBS should underperform credit.

The view in credit

The immediate risk in credit is from companies with high fixed costs and a sharp drop in revenue from current efforts to avoid coronavirus infection. Companies with the highest leverage are first in line. As for the consumer, that is a story of generally continued strength with low unemployment, strong income, rising net worth and low debt service as a share of income.

john.killian@santander.us 1 (646) 776-7714

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