I have written before that one of my concerns for the coming years is that at some point the support measures that have been introduced to help businesses survive this crisis will have to be removed. One major development will be the re-introduction of covenants on loans to ensure a company that is insolvent cannot borrow any additional funds and lenders have a decent chance of getting their money back. This crisis will inevitably create a number of zombie companies that will be so highly indebted that they will only survive with permanent support from lenders or the government. The worst we can do is keep these zombies alive out of a fear of a spike in bankruptcies.
However, if we want to avoid such a proliferation of zombie companies, we need to become more stringent with our credit assessments again. At the moment, this re-introduction of covenants and other measures to limit credit risks is scheduled in most cases for 2021 and 2020. And it is entirely possible, I would even say likely, that at that point, we will see a wave of downgrades both in the loan market as well as the corporate bond market.
The risk of a credit crunch in corporate bond markets is particularly high for bonds that get downgraded from investment grade to high yield. Many institutional investors are forced to sell bonds that lose their investment-grade status and thus react with a rapid sale of bonds that may be at risk of a downgrade. Unfortunately, it is exactly in the lowest investment-grade rating category (BBB rating) where an exceptionally high share of bonds already has a negative credit outlook.
Share of bonds in the EU with a negative credit outlook
Source: RADAR and ESMA calculations.
The problem becomes even more urgent if we realise that the investors that hold most of these BBB bonds are investment funds and insurance companies. Both of these investors might have to sell large amounts of bonds very rapidly to avoid a breach of their investment guidelines. We have already seen a mini sell-off in corporate bonds in March and April this year, when corporate bond funds saw outflows between 5% and 10% of their net assets and were forced to sell corporate and high yield bonds indiscriminately, creating a spike in bid-ask spreads as liquidity evaporated.
Holders of BBB rated non-financial corporate bonds (Euro and Sterling)
Source: SHSS, CSDB, and ESRB.
It is entirely possible to see a slow-motion credit crunch similar to the 2008 financial crisis or the Eurozone debt crisis develop next year or the year thereafter. So far, at least, the downgrades of BBB-rated debt in the EU is following eerily close in the footsteps of these two recent crises.
Cumulative downgrades of BBB-rated Euro debt
Source: S&P and ECB. Note: Horizontal axis is weeks into the crisis, vertical axis is percent of BBB bonds downgraded to junk.