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A historic rush to cash

| March 20, 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.

The list of historic efforts to address coronavirus and its impact on economies and markets seems to grow almost daily. Central banks have signaled almost no limits, if necessary, to deploying their firepower. Fiscal policy is starting to wind up. Rather than a crisis of monetary policy, however, it increasingly looks like a crisis of confidence in the credit of acutely distressed borrowers—both companies and individuals. Connecting dots across markets, these borrowers seem to be making a historic rush into cash.

The crunch is coming from a sudden stop in economic activity around the world. Quarantines and social distancing have cut off businesses that could be viable once the coronavirus pandemic passes. Transportation, restaurants and bars, theater and entertainment, retail shopping and a long list of other business will likely see revenues evaporate. Our chief economist, Stephen Stanley, estimates that US GDP in the second quarter could drop by an annualized 11%, with other economists projecting drops of more than twice that amount. But these same forecasts anticipate sharp rebounds later in the year. The businesses most affected by coronavirus are just trying to make it through the revenue desert. They are out looking for a cool, clear stream of cash.

Unfortunately, monetary policy is ill-equipped to meet the needs of temporarily distressed but otherwise creditworthy borrowers. Almost no commercial bank, no matter the cost or terms of money, will pass it along to a borrower about to see revenues fall off a cliff. Central bank liquidity is likely pooling in the financial system and on the balance sheet of companies and individuals already equipped to make it through. Distressed businesses and individuals seem to be conserving their own cash and selling everything they can.

Prime money market mutual funds for the week ending March 18 saw net outflows of $85.4 billion while municipal bond money market funds saw net outflows of $5.3 billion. US domestic bond funds for the week ending March 11, the most recent data, saw $32.3 billion in net withdrawals, the most in one week since at least 2007. Municipal bond funds saw $3.1 billion in net withdrawals that week. Only equity funds saw net cash come in the week of March 11. But the big winner has been government money market funds, with net inflows the week ending March 18 of $249.3 billion.

Benchmark corporate issuers still have access to the capital markets and continue to build cash. Berkshire Hathaway, Progressive, Coca Cola, PepsiCo, Disney, UPS and Exxon all launched multi-billion deals within the last week.

In the $1.2 trillion US leveraged loan market, borrowers have started drawing down bank lines of credit. SEC filings show $54 billion in draws in March alone, with more than three-fourths since March 16 (Exhibit 1). The median leveraged loan made in 2018 and 2019 went to a company with a ratio of earnings to interest expense of only 3.5x. A 70% drop in earnings would leave the median company able to cover debt but little else.

Exhibit 2: Leveraged companies have started tapping lines of credit

Note: new draws on lines of credit by SEC-registered borrowers in the leverage loan market. Source: S&P Global Intelligence, Amherst Pierpont Securities

Markets in agency debt, agency MBS, ‘AAA’ CLOs, ‘AAA’ CMBS and other fundamentally sound cash flows have traded in wide and often disorderly markets, presumably a sign that portfolios needing cash have chosen to sell whatever can be sold most easily.

Despite calls to equip the Fed to buy corporate debt and possibly other assets, the market still faces the challenge of getting cash to temporarily distressed but otherwise creditworthy borrowers. Federal governments should consider guarantees on emergency bank loans to these borrowers. The federal guarantee solves the problem of lending to a temporarily distressed borrower. The commercial banking sector has relationships with many of these borrowers and often knows their balance sheets well. The banks could determine creditworthiness based on 2019 or other trailing financials. And bank regulators, already in place, could monitor execution of the program. The banking system becomes an efficient channel for distributing relief.

The visible toll of economic damage already underway only looks likely to rise in the coming weeks and months. Demand for cash should continue, and markets should remain volatile.

Investors with the luxury of ample cash on hand have opportunities to buy fundamentally sound cash flows at often historically wide spreads. Beyond cash flows guaranteed by governments or federal agencies, a range of public and private issuers have enough cash to make it through this crisis and come out on the other side stronger. That is exactly what every liquid investor should be looking for now.

* * *

The view in rates

The current 0.85% rate on 10-year Treasury debt implies an average real rate of 9 bp and inflation of 76 bp. Futures now imply policy rates at zero-bound for at least the next year. Fed policy is likely to only get more pronounced unless fiscal policy gets traction.  Given the tremendous monetary and fiscal stimulus working its way into the economy, a quick ebb in the coronavirus pandemic should threaten the rates market with visions of inflation and continue to sharply steepen the yield curve.

The view in spreads

Spread products remain almost complete at the whim of demand for liquidity. Eventually, portfolios with cash will begin buying fundamentally sound cash flows at wide spreads. That should start the process of returning some order and a framework for relative value to the market.

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. Until the arrival of pandemic, the consumer balance sheet has been extremely strong. The coming sharp rise in unemployment should change that.

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

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