This time is different
Back in February of 2020, the weekly reporting on supply chain impacts from the earliest COVID19 lockdowns in China that we were receiving from our corporate borrowers helped us understand how serious the pandemic could be.
In March, our London based public markets teams reported on extremely tight liquidity conditions in traditionally liquid credit markets allowing us to pause our private origination activity and pivot into public markets.
And in April and May, our securitised credit teams who were receiving weekly hardship reporting on our private portfolios started reporting positive signs, particularly from consumer borrowers, identifying the recovery in fundamentals.
So as many of us sit in bedrooms, at kitchen tables or home offices, locked down the same way we were almost 18 months ago, we thought we’d go back to our investment teams and ask why these lockdowns seem different and then ask them to look beyond the lockdowns, into 2022 and beyond.
First question, why is this time different? We’re locked down again. Government support is not nearly as strong with no JobKeeper or JobSeeker, early access to super is done with and banks are no longer being “encouraged” by regulators and politicians to provide forbearance.
Michael Bors, Public Corporates (Sydney based): The main difference now is that CFO and corporate treasurers can plan balance sheet settings with a much higher confidence interval around a more permanent reopening scenario. While the start of reopening in the domestic economy has of course been delayed by the delta variant, there isn’t a base case need to hoard liquidity to solve for what was in March of 2020, an unknown vaccine development timeframe. The base case has also been helped along by rating agencies displaying remarkable patience for COVID impacted credits. While from a bondholder point of the view, the Australian experience was another example of the so called ASX put in action – a dynamic that is hard to rely upon but impossible to discount. A local banking system that has become overcapitalised and flooded by deposits and cheap funding from the Term Funding Facility (TFF) has also shown a broad-based preparedness to provide covenant waivers.
M&A isn't (yet) surging but news flow such as the privatisation proposal for Sydney Airport arguably has wider implications by putting a floor under the equity value of a heavily COVID impacted sector from private sources.
David Hoskins, Private Corporates (Sydney based): The initial outbreak of COVID saw borrowers immediately and fully drawing down on their revolving credit facilities, for fear of lenders restricting access to funding in the face of falling earnings. This time around, borrowers have entered the current lockdowns flush with liquidity and more confident how to operate in the face of the present stay-at-home orders. Liquidity positions, whilst previously benefiting from Government support in the form of JobKeeper and commercial rent moratoriums, have primarily benefited from the resurgence in consumer spending across most sectors and an increase in government stimulus spending on the likes of infrastructure related projects. The confidence among borrowers has also been aided by the collaborative approach taken by lenders when COVID first struck to provide the necessary accommodation to waive or relax financial covenants and to support borrowers more generally through the periods of depressed trading brought about by COVID. Borrowers, rightly, have the expectation that lenders will again provide a similar level of support given the issues being experienced right now were not brought about by mismanagement but by an exogenous event outside of their control.
Stephen Martin and Matthew Moore, Private ABS (Sydney based): When it comes to hardship applications, we observe several key differences from a lender perspective to the 2021 versus 2020 approach, namely:
- Increased borrower education. Borrowers now understand that loans will increase or their term will extend after their hardship period ends;
- Reduction in major bank PR. Less large-scale promotion of ‘payment holidays’, with some majors restricting COVID assistance to affected LGAs only; and
- Hurdles to getting assistance. Borrowers generally need to provide proof of financial hardship due to COVID, effectively removing ‘opportunistic’ borrowers from COVID pools.
The soft-landing approach by government with targeted stimulus remaining in place, alongside reduced discretionary spending and record low interest rates has also improved serviceability for existing mortgage holders. In our view, hardships are likely to remain lower even if lockdowns extend through the end of 2021, but these hardships are more serious. Unlike 2020, hardships are counting in securitisation arrears statistics though 2020 has created a precedent where lenders may look to re-classify these loans as hardship levels become more problematic.
Gerard Hargraves, Private Real Estate Lending (Sydney based): In 2020 the real estate industry was provided a clear framework to navigate the hardships of COVID induced lockdowns via the Retail and Other Commercial Leases Act and various moratoriums covering insolvency and deferral of interest on SME loans (with similar loan relaxations adopted in the corporate and institutional lending markets). Anecdotally, both landlord and tenants have behaved reasonably in sharing the commercial burdens of the 2020 lockdowns (some minor exceptions with some national chain retailers). The more recent lock downs have seen the reinstatement of the Retail and Other Commercial Leases Act which is addressing the current situation. Notwithstanding the formal moratoriums on SME loans have not been re-introduced, it is understood lending markets are adopting similar loan relaxations where necessary given the full re-opening of the economy is in sight.
Okay so it sounds like some of this is just about an expectation that this is temporary – so what does temporary mean to you?
Michael Bors, Public Corporates (Sydney based): Temporary for rated IG credits that are still suffering COVID impacts is defined by the rating agencies patience levels. We have been surprised by their preparedness to look though the impacts in some sectors and wonder if such credits were unrated but seeking new ratings would the outcomes really be same? But having waited this long for a recovery we think they would struggle to justify a range of downgrades now. In this regard, credits such as Qantas can probably resort to more non-core asset sales rather than raise a second round of new equity. All this assumes that vaccine efficacy doesn’t fade too quickly or is threatened by another variant.
For less impacted or even thriving sectors, temporary is defined by shareholders demands for capital returns despite only taking a very brief pause in 2020.
David Hoskins, Private Corporates (Sydney based): The expectation certainly is that this is a temporary situation depressing earnings, however, just how ‘temporary’ really depends on the industry in question. While retailers have largely been able to pivot quickly and successfully to Click & Collect and online fulfilment models and therefore no longer require any form of lender support, other sectors are not expected to bounce back as quickly. Sectors such as cinema exhibition, outside school hours care, commercial laundries, gyms, airlines and even private hospital groups (the latter affected by the restrictions on elective surgeries) will require lender support well into CY22, given the near complete loss of earnings over the present lockdown, with covenant waivers currently extending through to the June and September 2022 quarters.
Gerard Hargraves, Private Real Estate Lending (Sydney based): Notwithstanding that the current state-based lock downs are understood to be temporary and the national economy will be re-opened by Christmas, the emergence from lockdowns will vary for different sectors of the real estate industry. Logistics, e-commerce and convenience retail are least impacted and will bounce back strongly versus student accommodation, high-end hotels and discretionary retail which will be much slower to emerge given the slower path back to international travel volumes and the acceleration of internet retailing. The office market is likely to land somewhere in the middle with some initial pressure on occupancy due to distributed work (working from home) offset by tenants’ demand for higher workspace footprint per employee as well as the inclusion of ‘wellness’ spaces.
The Delta variant has changed the conversation in Australia. We are now in lock step with the rest of the world in acknowledging that COVID19 has become an endemic disease which will likely be with us for the foreseeable future, much like the common flu. How does this change the conversation? Are there parts of the market where you have more substantial, longer lasting concerns?
Michael Bors, Public Corporates (Sydney based): The future demand for office space is perhaps the biggest as yet unresolved question simply because there isn't an overseas experience to point to and private sector policies on the matter still varied and fluid. Likewise, we think caution is warranted in assuming a rebound to a pre COVID level for business travel expenditure. What we don’t have doubt about is the shift to online goods consumption has been reset at a higher level of overall sales and in the shorter term (upon reopening) a change in the mix of consumption back towards services seems inevitable.
From a broader macro perspective what the Government does about the deficit and other issues like the post reopening migration policy in Australia will have implications for many borrowers.
And finally, from a markets perspective we would highlight the expansion of the range of tools employed by central banks during COVID. Markets are currently fixated on debating the timing of things like tapering, but we would be reluctant to assume the same playbooks couldn’t be redeployed if financial conditions warranted it.
Gerard Hargraves, Private Real Estate Lending (Sydney based): As Michael mentions above, the future demand for office space is somewhat unclear and is further complicated by what the post COVID norms will be for the setting of density levels, specifications of air conditioning/air filtration, reduction of high contact points (bathrooms, lifts, meeting rooms) and the incorporation of contact tracing systems (noting that all of these will also be applicable to the retail, hotel and student accommodation sectors as well). Many of these are substantive issues for which we don’t have answers as yet.
Lastly, lessons from offshore- they are already opening. What can we learn from the northern hemisphere markets?
Kieran Roane, Public Corporates (London based): The re-opening of economies has seen spending pick up but given resurgence of COVID cases cautiousness remains. UK savings rates increased in July despite the economy re-opening. Consumption of goods has been robust throughout the crisis, but ongoing supply chain issues look likely to persist, leading to prices in consumer goods remaining elevated. Consumption of services, which have been hit particularly hard hit through this crisis has seen a strong rebound (for example, domestic tourism is performing well- third quarter revenues for the theme park sector in the United States is expected to outperform 2019 levels), but this demand remains uneven.
With regard to real estate, a slow return to offices particularly in the UK has put pressure on commercial real estate with large rent-free periods being offered on office leases. In Europe the percentage of people returning is much higher given shorter journey times, and thus time spent on public transport, are much shorter than in the UK. City centres do remain under pressure as more people work from home with retail units in particular under pressure as demand fell and has not returned in these centres.
Despite the ongoing uncertainty, governments have been quick to turn their focus to the fiscal position of their respective economies. In the United Kingdom, a hike in the National Insurance levy of 1.25% has been announced to go alongside an increase in the corporate tax rate from 19% to 25% starting in 2023. Investors would be well served remembering that deficits are funded by taxes and the enormous public sector deficits from 2020 and 2021 will ultimately be repaid by the private sector in the years to come.
Pete Robinson, Investment Strategy (Sydney based): In having this discussion several themes have emerged. This time IS different. In general, businesses are in a much better position to cope with near term liquidity challenges and understand that any accommodations will have to be repaid in the future.
But over the longer term the view that things simply return to normal seems to be increasingly in the minority. If COVID19 is indeed an endemic disease, borrowers will need to permanently adapt business models. This will require investment. Additionally, and perhaps most importantly, governments cannot cushion the blow indefinitely. Already our offshore based peers are observing this. Fiscal spending will need to be more targeted and less voluminous in the next phase of this cycle which means the private sector will need to stand on its own two feet.
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Pete is Head of Investment Strategy for CIP Asset Management’s Fixed Income division. He is a portfolio manager for the CIPAM Credit Income Fund and the CIPAM Multi-Sector Private Lending Fund focussed on credit investments in both public and...