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COVID-19 vs the global financial crisis - key differences

In a credit markets review and outlook, Moody’s Capital Markets Research chief economist John Lonski has written that US financial markets have recovered in response to massive doses of monetary and fiscal stimulus. The combination of a firm dollar exchange rate and diminished inflation expectations underpin the market’s view that policymakers can afford to strive to limit any forthcoming upturns by bankruptcies, defaults, and foreclosures. Moreover, rightly or wrongly, markets sense that the US may begin to normalise by the start of May.

During the afternoon of Thursday, March 26, the market value of US common stock was 16.3% above its close of Monday, March 23, which was its lowest finish since November 11, 2016. Despite the outsized gains by equities and other earnings-sensitive securities since March 23, the 10-year Treasury yield barely rose from March 23’s 0.76% to a recent 0.82%.

The Fed’s renewed Treasury bond buying programme should prevent fixed-rate borrowing costs from rising to levels that might hinder business activity’s recovery from COVID-19. The 30.8% surge by the PHLX index of housing-sector share prices since March 23 stemmed from confidence in the longevity of low Treasury bond yields and the hope that COVID-19’s suppression of homebuying might fade during May. The 24.0% advance by the Dow Jones Utility Average since March 23 also reflects expectations of an extended stay by low Treasury yields.

Investment-grade bond issuance sets record high for month of March

The Fed’s recently announced lending and bond-buying facilities for US investment-grade corporations helps to explain the improved performance by corporate bonds rated Baa or higher. Even Bloomberg/Barclays Baa corporate bond yield fell from March 23’s 5.43% to March 25’s 4.96%.

After rising for each of the five days ended March 20 to 5.60% - the highest since September 19, 2013’s 5.64% - Moody’s Analytics’ long-term Baa industrial-company bond yield has since eased to March 25’s 5.28%. At the same time, MA’s long-term single-A industrial yield sank from March 20’s 4.15% to March 25’s 3.82%.

During the global financial crisis of 2008-2009, the month-long average of Barclays’ US$-denominated investment-grade corporate bond yield spread peaked in December 2008 at 594 basis points (bp), while its three-month average crested at the 567 bp of December 2008. By contrast, after most recently peaking at March 23’s 373 bp, the now Bloomberg/Barclays investment-grade bond spread has since narrowed to March 25’s 324 bp.

After widening to March 20’s current COVID-19 top of 418 bp, MA’s long-term Baa industrial company bond yield spread has since narrowed to March 25’s 383 bp. Thus, the long-term Baa industrial spread falls considerably short of where it resided during the most difficult months of the global financial crisis. For example, the long-term Baa industrial spread’s 527 bp average of October 2008 through March 2009 included December 2008’s month-long average of 589 bp.

Unlike the financial crisis, investment-grade borrowers now benefit from ample liquidity. March 2020’s US$-denominated investment-grade corporate bond issuance should soar higher by at least 44% year- over-year to a new record high for the month in excess of US$190bn, the latter handily surpasses March 2017’s old record high of US$154bn. Far different was September-October 2008’s 73% annual nosedive by offerings of US$-denominated investment-grade corporate bonds.

High-yield spreads yet to approach financial crisis widths

During the financial crisis, the month-long average of Barclays’ US$-denominated high-yield corporate bond yield spread peaked at December 2008’s 1,874 bp, while its moving three-month average crested at the 1,685 of January 2009. By contrast, the latest daily peak of the now Bloomberg/Barclays high-yield bond spread was set on March 23 at a narrower 1,100 bp. In response to announced stimulus programmes and an accompanying rally by equities, this high-yield bond spread has since narrowed to March 25’s 1,025 bp.

After ballooning from year-end 2019’s 375 bp to March 23’s current COVID-19 high of 1,220 bp, a composite high-yield bond spread has narrowed to March 25’s 1,126 bp. Once again, the high-yield bond spread has yet to resemble its 1,664 bp average of October 2008 through March 2009, never mind December 2008’s record-high, month-long average of 1,958 bp.

The composite high-yield bond spread now portends a climb by the US high-yield default rate from February 2020’s 4.5% to a 9.7% midpoint by December 2020.

High-yield EDF eases from recent high

Like the high-yield bond spread, the high-yield expected default frequency metric has eased from its latest high. Despite predictions of a 10% to 25% annualised sequential contraction by second-quarter 2020’s US real GDP and notwithstanding forecasts of a 20% to 30% peak for the US unemployment rate, the average high-yield EDF metric has climbed no higher than March 18’s 10.62% and has since eased to March 25’s 9.21%.

Though the average high-yield EDF metric is far above year-end 2019’s 4.18%, the metric has yet to sustain its much higher readings of 2008-2009. After averaging 11.05% for both November and December of 2008, the high-yield EDF metric’s month-long average climbed to 12.15% in January 2009 before cresting at February 2009’s record high of 14.58%.

The latest moving five-day average of the high-yield EDF metric now favours an 8.6% midpoint for December 2020’s default rate. The outlook from Lonkski at Moody’s notes that expected default frequency estimates are not directly dependent on corporate bond yield spreads. In brief, the EDF metric estimates the probability of a default over the next 12 months, where the default probability will be greater (i) the lower is the market value of a company’s net worth and (ii) the greater is the volatility of the market value of a company’s business assets.

Ultra-wide high-yield spreads are typically much thinner 12 months later

A composite high-yield bond spread averaged 1,125 bp during the six trading days ended March 25. In only nine months since the end of 1983 has the high-yield bond spread averaged at least 1,000 bp. The good news is that 12 months after averaging more than 1,000 bp, the high-yield bond spread was narrower by 906 bp, on average.

Such spread narrowing owed much to an accompanying 8.65 percentage point plunge by a composite speculative-grade bond yield. The averages for the nine months showing a wider than 1,000 bp high-yield bond spread were 17.52% for the composite speculative grade bond yield and 1,521 bp for the high-yield bond spread.

For 17 of the 18 months since 1983 showing an average high-yield bond spread of more than 900 bp, both the high-yield bond spread and the composite speculative-grade bond yield would be lower 12 months later. The average declines 12 months later for this 18-month sample were 591 bp for the high- yield bond spread and 5.77 percentage points for the composite speculative-grade bond yield.

The outlook report notes that the downside risks emanating from COVID-19 are both unknown and substantial. Though financial markets have rebounded noticeably from their latest bottoms, a return to March 2020’s lows cannot be dismissed until COVID-19 related risks recede convincingly.


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