The current coronavirus crisis is taking a heavy toll on the financial markets and the enthusiasm of investors. Recently, there have been many headlines about the appalling losses suffered by the major stock and commodity markets, about spikes in equity volatility and falling interest rates. But the fragile fundamentals of the $72 billion global corporate debt market may pose a greater threat to the economy and the financial system. Will the coronavirus pandemic cause the next global financial crisis? The answer with Boris Lefebvre.
The (likely) collapse of global demand
Since the global financial crisis of 2007-2009, global monetary policies have kept interest rates low, fuelling a corporate debt frenzy that has led to a 60 per cent increase in outstanding debt. Unlike the 2007 crisis, caused by an over-indebted financial sector lending to over-indebted real estate borrowers, the new crisis on the horizon will (most likely) originate in the “real” economy through the collapse of aggregate demand.
The longer the global pandemic persists, the greater the exposure of the underlying weaknesses in the balance sheets of indebted companies, triggering a wave of sales, write-downs and defaults. In this scenario, a combination of mark-to-market losses and defaults will reduce investors’ appetite for corporate credit risk, as well as that of financial institutions, which could destabilize the system and restrict the flow of credit through the economy.
Corporate Bond Market: Security Questioned
The global corporate bond market represents approximately $13.5 trillion in outstanding bonds worldwide, the vast majority of which is in the form of investment. It is in this market that the largest and most established companies access capital to finance their medium and long-term needs. After Treasury bonds, the investment-grade corporate bond market is generally considered the safest place to invest. This security is being questioned.
The composition of the market has changed considerably since the last financial crisis of 2007 – 2009. This is particularly true when considering the threshold for investment grade bonds, those rated BBB. For example, in 2007, the Barclays Global Aggregate Corporate Index was composed of 26% BBB; the proportion has now reached 50% (as of March 20, 2020). While this has lowered the average credit rating of the index and increased the risk of default on average, it has also increased the risk that the bonds will lose investment status due to the downgrade.
Life insurers will be hit hard
In Boris Lefebvre’s view, one of the groups most affected would be insurers, particularly life insurers, who are among the largest holders of investment grade credits in the world. Insurance companies are subject to strict regulatory capital requirements that vary according to the risk of the assets. In the United States, for example, the amount of regulatory capital requirement is multiplied by two to three and a half times for bonds downgraded as “non-investment grade” assets, which would have a negative impact on insurers’ capital and solvency ratios.
