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Blog Posts — April 1, 2020

Bank credit spreads: Will this time be different?

by Christoph Schon, CFA, CIPM

As share prices plummeted in late February and early March, corporate-bond risk premia exploded at rates not seen since the aftermath of the Lehman Brothers default. So far, spreads of financial institutions have essentially moved in lockstep with the overall market. This contrasts sharply with the global financial crisis and the Eurozone debt crisis, during which credit risk premia on bank bonds widened by another 150 basis points on top of the market average. The pattern is also at odds with recent equity returns, in which financial stocks have underperformed broad-market benchmarks by more than 10 percentage points. This begs the question: is there more to come or are things somehow going to be different this time?

The graph below shows the 5-year spreads of global USD-denominated corporate and bank bonds with a single-A rating. It highlights that bank spreads have been only marginally wider than the overall market for the past seven years, even during the Chinese stock-market turbulence in 2015/16. As we noted in our previous blog posts on corporate bonds and fallen angels, the market average has already surpassed the peak from the Eurozone debt crisis, while financial institutions would still have had another 50 basis points to go from the latest high point on March 20.

Average 5-year spreads over USD swaps for global corporates and banks

Source: Axioma Fixed Income Spread Curves

So, is the current environment is sufficiently different from the two historical time periods, or is history is destined to repeat itself? Both precedents indicate that risk premia for financial institutions could widen by up to 150 basis points on top of the spread increase already experienced by the overall market.

What is different this time…

One of the key reasons banks underperformed other sectors during both the global financial crisis and the Eurozone debt crisis was the fact that institutions held lots of “toxic” assets on their balance sheets at the time—assets that experienced sharp declines in value during the crises. In the first case, it was subprime mortgage-backed securities, and in the latter case it was debt from struggling peripheral sovereigns. The former is clearly not a problem now. On the contrary, the British government and commercial banks, for example, have already announced the option for struggling mortgage holders to request a three-month payment suspension. In addition, the Bank of England has instructed banks to scrap dividends and to cancel cash bonuses to executives to fortify their balance sheets against a likely recession.

… and what is not

The impact on and from sovereign debt, however, is much harder to foresee. As shown in the chart below, risk premia of European sovereign issuers over German Bunds widened significantly in the first two weeks of March. Not too surprisingly, the spread increase was most severe in Italy, which is at the epicentre of the coronavirus outbreak on the continent. The corresponding movement in the Spanish risk premium, on the other hand, seemed relatively modest in comparison, considering that the situation there is quickly deteriorating and rapidly catching up on Italy. One possible explanation could be that Spain is in a much better position in terms of its government-debt level relative to its GDP (<100%), compared with Italy (>130%).

10-year sovereign spread over German Bunds

Source: Qontigo

There is likely more to come, especially for peripheral countries

The recent announcements of fiscal stimulus and rescue packages around the globe can be expected to put upward pressure on government bond yields, both on the “risk-free” rates of the “core” countries and, even more so, on the borrowing costs of “peripheral issuers”, such as Italy and Spain. The latter two are likely to be hit hardest, as they are also among those most severely affected by the pandemic. Any disproportionate rise in financing costs for the sovereign is also likely to impact the financial sector in the country, as European banks, specifically, tend to hold large debt positions from their own government. This could result in a repetition of the so-called “doom loop[1] from 2010-2012, which, according to stress tests performed by the Qontigo Applied Research team, could lead to financial stocks underperforming the overall stock market by up to 50%.

So, to come back to the original question, it looks like there are major differences between the two previous crises. But at the same time—as with the coronavirus epidemic itself—we know that things are likely to get worse before they get better. We just do not know yet how bad it is going to be. Let us just hope that things are sufficiently different this time.

[1] As sovereign yields rise, banks, who hold these bonds on their balance sheets or use them as collateral for their funding, start to struggle and may even need to be bailed out by their government. This, in turn, leads to even higher borrowing costs and increasing yields for the government and so on.