May 8, 2020
“If Plan A did not work, stay cool.. The alphabet has 25 more letters”- Anonymous
As a result of the COVID19 outbreak, the world is currently witnessing the Fallen Angels phenomena. By definition, such phenomena occur when credit ratings of sovereign and corporate bonds are downgraded from investment category to junk. Attributed to the pandemic, revenues are declining and debt covenants are breached on the spot and not gradually. Simply, there were no warning signals to raise any flags regarding such imminent black swan situation. Consequently, this created an inevitable environment of rating downgrades limiting capabilities of raising new funds from both financial institutions and fixed income fund managers. The former will require imposing higher rates and tighter covenants to disburse debt. On the other hand, the latter will refrain from disbursing any dry powder funds in order to meet their mandates regarding investing in certain investment graded bonds. From the legal and technical perspectives, some analysts argue that covid outbreak is a force majeure case. Hence, this is not a genuine breach of covenant resulting from a specific operational or business model malfunction. Generally speaking, the whole world is passing through an economic phase where the worst case scenario is currently considered the base case model. This is evidenced by a U shaped recovery rather than a V shaped. In addition, downgrading could occur in the future for larger spectrum of countries and companies. Such economic circumstances and market dynamics raises a thoughtful question. How to stimulate demand creating a comeback opportunity to bonds?
To answer this question, we will tackle scenarios for issued and potential bonds. Also, it is assumed we are talking about LIBOR rated bonds. Hence, it is appropriate to recall that LIBOR is expected to be cancelled by 2021 and replaced by another reference rate. Most reports are recommending the SOFR rate to replace LIBOR. It is worthy to mention that SOFR is quoted at a lower rate than LIBOR. In addition, most central banks around the globe are currently interested in stimulating economies by engaging in bonds purchasing programs especially corporate bonds. Now, let’s alter some of the issued bonds parameters under downgrading circumstances. Downgrading necessitates implying a higher yield and hence a lower bond price. This impact is multiplied especially if accompanied by a massive sale wave from pension and fixed income funds that are prohibited from holding fallen angel bonds in their portfolio as per their investment mandate.
So how could we counter such situation? Frankly speaking, black swan crisis requires similar black swan counter measures. Simply, strip the selling yield from the LIBOR coupon rate. In other words, the issued bond selling rate today should be calculated based on the lower SOFR rate and not the LIBOR coupon rates. This will increase the bond price countering the downgrade and sales impact. Taking the argument a step further, central banks through their stimulus programs will purchase the corporate bonds in the open market at the implied SOFR yield rather than the previously issued higher LIBOR rate. Hence, providing the required liquidity for investors whom already purchased issued bonds. Actually investors might end up achieving a capital gain compensating their coupon stream. Another adjustment is including a transitional period of around 6 months where the coupon payment is referenced at SOFR rate. Consequently and post the pandemic, the bond coupons pays an altered reference rate of SOFR plus a markup equating it with the prevailing LIBOR rate at that future timing.
As for potential bonds, same could be applicable more or less for new issuance. Stripping the bond into principal or face value quoted at SOFR and coupons with increasing balloon payments referenced at SOFR and an equating markup to the LIBOR. Such thoughts could be applicable to some potential sovereign bonds especially for countries operating in a declining oil prices such GCC sovereign bonds. By the end of the day, LIBOR will be cancelled by 2021. The whole idea lies in the concept of speeding up the reference replacement process.
Finally, this article theme is an attempt to come up with a plan B. But as the opening quote states, there is still a possibility of coming up with another 24 backup plans. Just unleash your imagination and the road back to bonds heaven will guide the fallen angels..
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