As forecast last week, the spread of COVID-19 has generated severe financial market volatility, which was substantially worsened by the breakdown in production discipline within the global energy market, reflecting the stand-off between Russia and Saudi Arabia.

This has triggered further severe falls in global stock markets, a sizeable rally in safer debt instruments, and further risk aversion towards riskier assets:

• Early in the week, the entire US Treasury yield curve moved briefly to yield levels below 1%. Over one month, 10-year Treasury yields have declined by roughly 1%
• UK bond yields have moved to new lows, reaching negative yields for the first time. On 9 March two-year gilts traded to -0.04%, with an inverted yield curve driving the 10-year yield to -0.08%.
• Ten-year Bund yields have traded below -0.8%.

Counterbalancing this, credit default swaps and credit spreads are facing severe upward pressures.

• On 9 March, the Financial Times highlighted that US Energy sector junk bonds were particularly badly hurt, suffering both from the halving in oil price levels after Saudi Arabia announced at the weekend its plans to boost production aggressively, and the expectation of economic slowdown.
• It reported that over USD110 billion of debt issued by US energy firms was trading at yields a full 10 percentage points over US Treasury bonds, according to Ice Data Services data, breaching a commonly used indicator of debt distress. It noted that this represented 12% of the stock of energy sector debt but claimed that almost two-thirds of those instruments with sub-investment grade levels were now at distressed spreads.
• Emerging market bond spreads have now reacted, particularly for those countries heavily reliant on energy earnings. As an example, Ecuador's EMBI+ bond spread index stood at 2879 basis points on 10 March, versus 1531 basis points on 4 March. Between 5 and 9 March, Russia's EMBI+ index widened from 178 to 273 basis points, that of Mexico moved from 217 to 302 b.p.
• Expectations regarding Argentina's debt sustainability have worsened sharply: in the month to 11 March, its EMBI+ spread widened from 1953 basis points to 2947 b.p.
• Appetite for credit insurance has spiked: on 9 March, the IHS Markit iTraxx Crossover index surged by around 120 basis points at one stage, to around 500 b.p., its highest one day jump on record. Trading conditions were exceptionally volatile with thin market activity.
• Italian bond yields rose rapidly on 9 March, with its 10-year yield jumping over 30 basis points to 1.38%, reflecting the severity of the outbreak there and the growing damage it will cause to its economic activity and fiscal balances.

Despite these acute moves, and very sharp falls in global stock markets, by 10 March markets permitted a reopening of the high-grade dollar markets. JP Morgan, with a USD2.25 billion six-year deal callable after five years, and Starbucks were among four high-grade entities selling debt.

The limited issuance flow continued as the week progressed: on 11 March

1. IFC gained at least USD3.4 billion for a USD1 billion social bond, designed to help fund the maintenance of employment in developing countries and offset impacts from COVID-19. The pricing of the three-year instrument was tightened to 13 from 17 basis points over mid-swaps.
2. Danone attracted EUR5.8 billion of demand on 11 March for a EUR800 million seven-year deal. Its statement noted that the deal was "taking advantage of current market window favoring quality bond issues" to extend the firm's maturity schedule and reduce borrowing costs. It was priced at 0.571%.
   

Lebanon default and other events

Away from the major moves in global markets, other noteworthy developments include:

• As warned, Lebanon failed to make payment of USD1.2 billion to repay maturing debt on 9 March, with no suggestion that this would be rectified within the grace period. Shorter-dated instruments - whose fate had been unclear until the non-payment - fell sharply to join longer term bonds in trading at levels of mid to high 20% of their nominal volume, indicating that market participants now expect heavy capital write-offs during future debt restructuring, as forecast in depth in our recent coverage.
• On 6 March, Prudential Financial announced that its latest financing package of USD1.5 billion included a USD500 million Green bond, the first of its kind by a US life assurer. Net proceeds will be assigned to investments "which provide environmental benefits", being selected from a list of eligible areas including renewable energy, environmental management and pollution control, aligned with the UN Sustainable Development Goals. Prudential has established a Green Bond Council spanning several areas which will select eligible investments and report to investors.
• The UK's Municipal Bonds Agency, established in 2014 by 56 local authorities as a vehicle for local councils to pool their borrowing needs, has sold its first public bond. On 5 March, it raised GBP350 million of five-year debt, priced at 80 basis points over SONIA, on behalf of Lancashire County Council as sole end-user. The deal was twice subscribed.

Deutsche Bank has followed the example set by Banco Santander last year by announcing that it will not call USD1.25 billion of 6.25% Additional Tier 1 perpetual bonds when they first become callable on 30 April. It stated that this reflects "the bank's stated strategy of evaluating all call decisions primarily on an economic basis" to manage its funding costs. Given the severe levels of risk aversion prevailing and heavy recent markdowns on AT1 bonds for other banks, this is unlikely to represent an isolated decision.

Despite the difficult conditions, IFC website reported on 12 March that South Korea's Kookmin Bank plans to seek USD500 million of Tier 2 dated subordinated debt.

We have noted that on 5 March, Volkswagen issued a Green Finance Framework, designed to fund "sustainability projects ...such as e-mobility", which will be selected by a newly-formed Green Finance Committee and be subject to independent assessment and regular reporting. In this regard, it follows the recent precedent set by Toyota, which issued the US auto sector's first Green bond.

Outlook and implications

Saudi Arabia's boosting of oil production and Russia's rejection of production cuts have generated severe uncertainty in the energy sector, coming on top of the recessionary impacts of COVID-19. The surge in junk bond yields in the sector reflects far-greater perceived default risk, with energy oriented emerging market countries also badly affected.

This stand-off is unpredictable, but our initial assessments suggest that Russia has had time to prepare for such conflict, knowing it would reject OPEC calls to lower its own production. Both countries nominally have sizeable forex reserves representing over 20 months of estimated import cover, suggesting that resolution of the stand-off may be a drawn-out matter, increasing the adverse pressure on other energy producers.

From a wider perspective, additional monetary measures, such as the UK's half point rate cut to 0.25%, may offer some temporary relief to the markets, but we continue to doubt their ability to counteract the fallout of COVID-19, which this week has been on a rapidly expanding trend outside China. As previously suggested, markets and policy makers face new risks with which they are unfamiliar: the threat of periodic moments of "panic" remains elevated. These are troubled and uncertain times for financial markets: as we have flagged repeatedly in recent years, there is high risk of market imbalance during periods in which risk perceptions change quickly.

Elsewhere, we would expect more banks not to exercise first call rights on AT1 and subordinated debt, despite the past tradition for such calls to be employed. In current conditions, refinancing such instruments would be difficult and potentially costly, and it would make no sense for banks to reduce capital at a time of growing economic pressure on their profitability and asset quality. The expectation of increasing capital needs - for example if banks face sharply-larger losses on highly-leveraged lending - is likely to add to pressure on bank capital instruments.

Posted 13 March 2020 by Brian Lawson, Senior Economic and Financial Consultant, Country Risk, S&P Global Market Intelligence