Canada has been hit by a credit crunch that is threatening pension funds, individual savers, homeowners and small businesses, with broad implications for a national economy already partially paralyzed by the novel coronavirus. This financial crisis showed up in recent days in what may be the beginning of a run on fixed-income funds, including those with portfolios in investment grade (IG) companies, such as the Royal Bank and Bank of America. It is even worse for lower credit IG companies like BBB and BBB- rated issuers that may be downgraded to so-called junk status due to an inability to refinance. The credit agencies, heavily criticized for their slow reaction to the last financial crisis, started downgrading late last week, with more almost certainly coming.
In recent weeks, IG bond prices have fallen by 20 per cent, reflecting the precious little comfort provided by most revised corporate operating forecasts. The increase in bond yields occurred in the face of two 50-basis points bank rate cuts to 0.75 per cent in response to the pandemic and the collapse in oil prices. Increasingly, IG bonds are owned, either directly or indirectly, by individuals with asset managers and in mutual funds, pension plans, saving accounts and insurance companies. All these players are now all experiencing sticker shock, while some are locking in losses through redemptions. In response to the market dysfunction, several fund managers apparently asked securities regulators for a blanket exemption to temporarily suspend redemptions.
U.S. bond funds experienced a record outflow of $108 billion last week, almost four times the previous record, with $90 billion moving to the money market. Meanwhile, investment banks are no longer willing or able to inject cash to stabilize markets.
The Bank of Canada (BOC), Federal Reserve, Bank of England and European Central Bank (ECB) have provided monetary stimulus through rate cuts and repurchase (repo) facilities for government bonds and other asset classes, including commercial paper in the U.S. Canada’s Office of the Superintendent of Financial Institutions (OSFI) eased capital reserve requirements, cutting banks’ domestic stability buffer by 1.25 per cent, which freed up an additional $300 billion of lending capacity. The BOC also enhanced liquidity by agreeing to buy banker’s acceptances from financial institutions. The three U.S. federal banking agencies encouraged banks to use their capital and liquidity buffers to lend to customers. While US and Canadian central banks instituted programs to support money market funds, they have not supported losses on longer-date bonds. The secondary market for corporate bonds therefore responded quickly to investor fear, if not panic.
Meanwhile, COVID-19 is devastating the economy, with no assurance that severe restrictions will successfully flatten the curve to let our health system cope with the influx of patients. We do not know how many people will become sick and require hospitalization, how long the health crisis will last, when businesses can start operating again or even, definitively, whether infections will reoccur. What we do know, but are reluctant to say, is that even if the infection rate is not fully contained, there will be a moment when government will have to let commerce restart or the financial consequences will become untenable. The extreme market volatility and downturn mainly reflect fear about the catastrophic consequences of a prolonged economic shutdown.
Canada’s big six chartered banks are lending money to their best customers and deferring mortgage payments for up to six months. But they are holding back on lending to lesser credits. Also, some large non-bank lenders are reducing their exposure to mortgage lending, which disproportionally hurts smaller builders and residential homeowners.
The ECB and Bank of England have facilities to purchase bonds from non-bank issuers, investors and even individuals who need funds to stay in business. This assistance is desperately needed in North America to avoid liquidity-induced bankruptcies and a cash crisis for fixed-income investors. The moral hazard counter-argument to government assistance does not apply to a black swan event, which is unpredictable, widespread and highly consequential.
Minister of Finance Bill Morneau should use his bully pulpit to “encourage” the banks to employ their expanded lending capacity for the benefit of temporarily distressed but credit-worthy companies.
The government could also authorize a sizeable facility for the BOC to purchase non-financial IG corporate bonds of any maturity. That would free up the banks to re-lend and help stabilize the non-bank financial sector, which has provided liquidity to retail investors since the financial crisis. Alternatively, the government could guarantee IG corporate debt issuance during the next six months for debt maturing within two years.
Extraordinary challenges justify extraordinary initiatives. The government should act immediately with policies to deal with a systemic credit crunch that risks wreaking havoc on a faltering Canadian economy.
Joe Oliver was minister of finance in 2014-15.