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Sunday, March 15, 2020

Primary Credit Market Is Key

We are in the middle of a bear market for risk assets, and the key question is trying to figure out what turns this around. My argument is that it is going to be very difficult to read the entrails of market chart patterns, pandemic data, and policy responses to time the bottom. However, if one is not attempting to be a hero forecaster, one key thing to look for is a the resumption in corporate bond issuance. (This is the primary credit market; the secondary market is trading of existing bonds among investors. Pretty much all market data and colour is based on the secondary market.) My feeling is that policy makers are either going in the right direction (or are being dragged by the private sector), so policy uncertainty is becoming less of an issue. Instead, we are stuck more with the hard scientific question as to the effectiveness of social distancing, as well as medical treatments.

My Reading: Yup, It's Like 2008

As an outside observer, the markets look like they are operating in the same fashion as they did in 2008. That said, some things look better, and others are scarier. The key thing to realise is that a lot of the action is hidden away, so it is very hard to know what exactly is happening. Nevertheless, if one is not attempting to sound like a know-it-all, we can guess what is happening underneath the hood.

Falling prices across asset classes implies margin calls. These margin calls are either the result of old-fashioned borrowing to buy financial assets, or the result of financial derivatives -- which are implicitly levered side bets on markets.

Although the corporate debt market is extremely important for the daily functioning of industrial capitalism, the extreme diversity of instruments means that the corporate market is inherently illiquid. When times are good, dealers and active investors turn over relatively small amounts of corporate bonds at a high velocity. The issue is that these actors have strong balance sheet constraints. For example, most corporate bond managers have tight risk limits relative to their index. They might be trading back and forth all day, but they have very little capacity to move their fund into or out of other asset classes (including cash).

Balance sheet limitations on active traders means that they get overwhelmed by large flows. Normally, those big flows are primary issuance -- and that issuance makes its way to end investors, who are largely forced to sit on the bonds. Dealers have to keep an eye on trends to match the flow of primary issuance to the needs of those investors. However, fund liquidations cannot be controlled.

The only way to absorb liquidation pressures is for entities with balance sheet capacity to pivot their balance sheet towards corporate debt.

What Brings The Investors In? Pain.

Corporate bonds are inherently an inferior asset class from an asset allocation standpoint. They lack the correlation advantages of government bonds, yet lack the potentially open-ended return upside of equities. Meanwhile, corporate managements are actively trashing their balance sheets to benefit equity holders. Buying corporate bonds is literally making you the opposite side of people who are running the firm that generates the cash flows that support the financial claims.

Instead, corporate bonds are attractive to fixed income managers who want to outperform the index by X basis points per year. This works most of the time -- until a crisis hits. (But luckily, since practically every fixed income manager is overweight credit, you still end up in the middle of the pack.)

To bring in the asset allocators, credit needs to get really, really, cheap. Given the illiquidity of the secondary market in a crisis, the spreads you see quoted in commentary are largely figments of matrix pricing algorithm's imaginations. Trying to find a trader at a market maker who is not in the bathroom for several hours each day is extremely difficult. (This might explain the toilet paper hoarding.)

We need a big fat primary issuance that end investors can get a big piece of in order to draw them in. So they wait until the opportunity presents itself. The classic example are the large preferred share purchases made by Warren Buffett at the depths of the Financial Crisis. (Link to a retrospective article from 2013.)

They will not ring the bell at the bottom, but you should expect some big fat deals to be done at about that time.

How Scary Is It?

Right now, the biggest market worry I see is the situation of European banks. It seems entirely likely that risk management is vastly improved versus the situation in 2007. However, European banks are tied to the hip to euro area sovereigns, and the euro is system that is designed to fail in a crisis. Euro sovereign failure worries were not yet at the forefront in 2007-8, but subsequent events showed that this risk cannot be ignored.

Gauging the risk is giant exercise in political economy and moral hazard. If the euro area authorities followed the rules that they make all the weaker actors follow, the system is doomed. However, that would be disastrous for the governing elites, particularly for the ECB (which would revert to being a collection of low status central banks). The question is at what point will they bend the rules to save the system, and whether rigid hard money ideologues will sabotage such rule bending.

The base case should be that the system will hold, but the uncertainty will force European banks to step back from their market-making roles. Given their importance in market-making, this is enough to disrupt global financial markets.

After that, risks seem to be at the sector level. Even with governments throwing around bailout money, firms will fail Nevertheless, these losses should mainly be absorbed by portfolio investors. These are entities that have just lost over 25% on most of their equity holdings, which are typically a much larger weight than corporate bonds. Getting haircuts on a slice of their corporate bond holdings is not their biggest concern.  One may look at the example of the losses of telecoms/technology firms being absorbed in the aftermath of 2000-2001 to see how this played out.

Sector Risk

Some of the uncertainty has been peeled away. We still do not know what the casualty toll will be, but we know what the policy response is: social distancing. Unless a vaccine arrives very soon, we are likely to be going forward to a period of rotating school closures, and closures of places where people gather.

This will be devastating to any firm whose business plan involves huddling large groups of people together. However, some form of "normality" will return, and people will still be doing something. Firms will be selling products to people, helping them do whatever they are doing.

Obviously, good credit analysis is going to be a high valued-added activity in the coming days. However, even macro types will be able to judge when we have reached a point where spreads are more than enough to cover plausible default risks, and it is safe to put money to work in corporates.

What Should the Authorities Do?

The main area where traditional policy responses will be effective is reducing the risk posed by the European banks. Obviously, saying stuff like it is not the ECB's job to stabilise government bond spreads has to be avoided. Liquidity facilities eliminates perceived risk around the market-making system, so credit analysts can focus on the risk of non-financial issuers.

Beyond that, it is a waiting game. Social distancing needs the backing of government, so that everyone is in the same boat. Income support and forbearance on debt payments (and similar) to keep people afloat as we adjust to the new lockdown regime. Barring a vaccine (or breakthrough treatment/testing regime), I am not seeing the ability to engineer a relatively rapid turnaround, since caution about social distancing is likely to be persistent.

Best wishes to everyone.

(c) Brian Romanchuk 2020

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