This quote is the latest from Moody’s:
The credit shock created by the coronavirus pandemic is completely unprecedented, given the number of geographies and industries affected, and the lack of clarity as to when the economic implications of the pandemic will likely be resolved. Over the coming weeks and months we will evaluate each CLO (collateralized loan obligations) placed on review. It is quite possible that stress in the global corporate sector will grow. If this indeed comes to pass, we may end up downgrading more of the underlying CLO collateral. In such an event, more CLO tranches could be placed on review and/or potentially downgraded. We will continue to evaluate the impact of the global pandemic on the underlying CLO collateral and its implications for CLOs and, as warranted, adjust CLO ratings accordingly.
Why is this important? Consider the energy patch. Many of the loans of oil and gas companies use reserves as collateral. If the collateral is worth less (not quite worthless) then the lender (banks) notifies the company it’s in violation of the loan arrangement. The company cuts capital spending, fires people, reduces its dividend etc. but these measures do nothing to relieve the ‘debt’ problem. The company is technically in default. The next step is an adjustment (downgrade) in the debt rating of the company – which means fund managers may no longer be able to own their bonds. The company then finds it more difficult and expensive to raise capital. And so on…
This process begets a credit crisis – it happens across a plethora of industries. This is why I published (March 11) the (prescient) article I called “It’s another credit crisis.”
As I mentioned in my prior post, corporate spreads should widen again as defaults begin to rise, as they did in previous crises.
I’ve written about my concern about the real estate industry (particularly REITs). This is from today’s Globe & Mail:
First Capital REIT, RioCan REIT and SmartCentres REIT issued updates after the market close on Tuesday. RioCan said it has collected 66 per cent of gross rent for April, while First Capital and SmartCentres have each received about 70 per cent. (Gross rent is the base rent, plus shared costs such as maintenance and realty taxes.) Last week, H&R REIT said it had collected just 56 per cent of retail rent for April, driven largely by non-payment at enclosed malls, although some clients had reached agreements for deferrals.
What begins as a cash flow problem soon becomes a collateral problem. The valuation of the collateralized asset is based on the rent it generates – less rental income and the property is worth less. Potential for default. The dilemma for the lender – receiving payments (thanks perhaps to government initiatives to help businesses) does not change the fact that once the collateral is devalued the loan agreement is violated.
That’s the bad news. The good news is that ‘so far’ the stock markets have held their own, no doubt because the prospect of some rate of return is better than close to zero in fixed income markets. During the Financial Crisis, eventually no rate of return was deemed infinitely better than a negative rate of return. The question is will this happen again?
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