Central Bank Liquidity and the Slippery Slope of Solvency: Part II
In the first part of this series we discussed the enormous size and scope of the unprecedented actions taken by the U.S Federal Reserve Bank and the enormous balance sheet expansion and liquidity being pumped through the system. Today we will explore what this means for some of the more highly leveraged names in the high yield market.
As briefly touched on in Part I, the corporate programs the Fed has established include buying bonds and providing loans to investment grade companies (i.e. rated BBB- and above) in both the primary and secondary market. While the programs currently have $850 billion of capacity, it could easily grow if needed. One of the implications of the Fed intervening in the investment grade corporate bond and loan market was the removal of a major tail risk with respect to a negative feedback loop that was forming between secondary market liquidity and primary market activity. If you recall just a few weeks ago, the secondary market was exhibiting significant price gaping, blowing out of credit spreads and virtually no liquidity with good quality corporate borrowers unable to access capital markets to fund themselves. If left unchecked, this situation had the potential to spark bankruptcies of solvent businesses that had hit a liquidity wall and could have triggered the onset of a full-blown credit crunch, a much more significant contagion along with a deeper recession / depression. Instead of this potential outcome, the Fed became the buyer of last resort and is effectively backstopping the credit market for U.S. businesses, but NOT for all U.S. businesses (we will come back to this).
To round out the discussion of tail risks, another significant tail removed by the Fed was permitting companies that held investment grade ratings as of March 22, 2020 and are subsequently downgraded to high yield or junk (but not lower than BB-) to qualify for the Fed programs (aka “fallen angels”). Given the decaying quality of BBB credit over the last several years, the potential for mass downgrades in the wake of the COVID-19 could have overwhelmed the high yield market given the enormous size disparity (BBB market is $2.5 trillion versus $1.0 trillion high yield market). Under this scenario there was a risk the market could have frozen entirely, unable to cope with all the new entrants into the credit indices, ETFs, lack of dealer liquidity, price / yield gaping, etc. Given the Fed will step in and buy these “fallen angels,” the potential for a dislocation is greatly reduced at market level for high yield as well.
Avoiding a corporate credit event
While the Fed’s actions have mitigated a corporate credit event at market level for the time being, with seemingly unlimited support for investment grade companies and higher quality recently “fallen angels,” legacy high yield borrowers do not have a Fed back stop and fundamental price discovery should continue. Companies that have over leveraged balance sheets and are burning cash will likely need to be restructured as the Fed has not bailed them out. In fact, we have seen some high-profile Chapter 11 bankruptcies in high yield already, with J-Crew, Gold’s Gym, Frontier Communications, Quorum Health, etc filing for protection following the Fed actions, while JC Penney and Hertz Global are rumoured to be finalising the paperwork as well.
Given the Fed is NOT providing liquidity to high yield borrowers en mass (for the time being), the market will likely price the solvency of these businesses more organically. Whether that’s balance sheet solvency (i.e. capital structure) or cash flow solvency (operating structure aka a broken business). Obviously over the long term, no amount of liquidity will save a broken business, while a broken balance sheet will destroy a lot of capital and replace existing shareholders.
As we know from Japan, keeping zombie firms alive with liquidity is an option, but it creates an enormous dead-weight loss in the economy and we’re not sure the Fed is looking to go down that road. All this of course creates an enormous opportunity for Montaka Global on the short side, while the market seemingly prices in a “V-shaped” recovery for the entire corporate sector, we believe there will be a material amount of capital destruction before we return to levels of activity we had become accustomed to prior to COVID-19.