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Liquidity crisis avoided - now to dodge the solvency crisis

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Sovereign and corporate debt has rocketed during the coronavirus pandemic, as liquidity became the essential plaster to cover the almost overnight collapse in consumer spending. European treasurers might be tempted to spend 2021 shying away from the bond market and licking their wounds. This is the wrong choice.

Borrowers are still reeling from the economic fallout of the pandemic. The sudden and rapid fall in earnings made up for by borrowing sent debt metrics to dizzying heights. Oil major BP, to pick one example from many, saw its debt to Ebitda leap from 1.5 times in 2019 to an expected 3.26 times for this year.

The picture is similar for sovereigns, with Spain, Italy, Belgium and France running budget deficits of over 10% of GDP this year, according to European Central Bank estimates.

Treasury officials are right to be alarmed by these figures, and a gut-instinct reaction might be to hunker down and wait for earnings — or GDP at the sovereign level — to rise and organically nibble away at the oversized leverage ratios. This is the wrong approach.

The bond markets have never been more welcoming. The US Federal Reserve and European Central Bank are buying debt at unprecedented levels. The ECB delivered an additional €500bn of extra purchasing power this week with little indication of slowing down, in spite of the vaccines being rolled out in the UK on Tuesday, with mainland Europe presumably close behind.

In a market where central banks play such a colossal role, it will be difficult for sovereigns to default. Central banks have all but promised to ensure a stable and accessible market in which debt can be refinanced cheaply. In such a market, though headline debt to GDP figures may scare, the more relevant statistic is debt service cost to revenue.

So, while Spain’s debt to GDP ratio rocketed over 110% this year, the average yield of its new bonds for the past four months has been negative. In that time alone, the average interest Spain pays on its portfolio has fallen 9bp. Since the start of 2019, it has fallen 57bp.

Corporate borrowers grappling with lost revenues may face genuine insolvency threats but both groups have the same opportunity.

Borrowers need to be aggressive. Spreads have pushed tighter throughout the crisis on the back of central bank largesse, despite the worsening fundamentals.

Nobody can honestly say that the business environment of early December looks as good as it did in the pre-pandemic days of January, yet corporate spreads are at the same levels and sovereign yields have never been lower. The Europe Main hit 45bp this week – within 1bp of where it traded for most of January.

Some have already started taking advantage of this. BP completed a European record $4bn bond buyback in September, using the cash it got from a $12bn debut in the hybrid debt market – another useful balance sheet protecting tool – and analysts are expecting the company’s leverage to fall back down to a far more palatable 1.66 times in 2021.

Central banks’ determination to provide endless liquidity and market access means that borrowers, though they may not need the extra cash, can hit markets to smooth out their redemption profiles, pay off old high coupon bonds and place themselves in the best position possible to pay off their mounting debt burdens. Liability management should become the focus of treasury departments next year. Use the abundance of cheap debt to get rid of the expensive stuff.

Low rates will last a good while, but not forever. If the vaccine rollout goes as planned and Europe’s economy recovers, the fiscal stimulus and quantitative easing will swiftly lead people to expect inflation to rise, which will slowly start to drag up long end rates.

When sovereigns and corporates stop being able to roll their maturing debt over at cheaper levels, then we will be approaching a solvency crisis. When that day comes, borrowers will certainly still have huge debt piles, but hopefully they will have taken every opportunity to mean the burden of servicing them is as light as possible.

Claudio Borio, head of the BIS monetary and economic department, said on Monday that we are moving from the liquidity to the solvency phase of the crisis. Central banks have effectively neutered the liquidity crisis. Hopefully, the same remedy can work to mitigate the effects of a solvency crisis.

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