After weeks of pessimism about how the $10 trillion corporate debt sector would fare as the coronavirus outbreak has brought the U.S. economy to a near-halt, it appears the dominoes are beginning to fall.
On Tuesday, Delta Air Lines saw its credit rating downgraded to “junk” territory by S&P Global Ratings. Already at the lowest investment-grade rating of BBB-, S&P cut the airline down to a BB rating—demoting Delta into high-yield, speculative territory on concerns over declining bookings and revenues due to the coronavirus outbreak’s devastating impact on commercial air travel.
The move does not come as a great surprise, given that analysts have forecasted deteriorating credit profiles across the airline sector as the outbreak has escalated in the U.S. over the past month. Fitch Ratings expressed such concerns earlier this month in a note that pointed to “risks that [air travel] demand takes materially longer than previous shocks to recover,” and last week revised its outlook on Delta and four other airlines to negative from stable.
Amid all this, the airline industry—as well as airplane manufacturer Boeing—has been in the spotlight as potentially needing financial assistance from the federal government in order to survive. As Congress continues to hash out the details of an expected $2 trillion stimulus package, passenger airlines have been earmarked for up to $50 billion in federal aid, which could entail everything from government-backed loan guarantees to direct cash grants and tax relief. The prospect of taxpayer assistance has raised eyebrows, given the extent to which airlines have invested cash flow into buying back their own shares over the past decade.
But even with help from the government, falling credit profiles pose trouble for airlines as they look to tap private lines of credit in order to stay afloat. Having reportedly been in discussions with lenders including JPMorgan Chase for more than $2 billion in short-term financing, Delta secured a new $2.6 billion credit facility last week and also drew down $3 billion from existing credit facilities, according to research from both S&P Global and Morningstar. That spotlights the extent to which airlines have become reliant on borrowed funds as they continue to slash operations; in a March 20 memo to employees, Delta CEO Ed Bastian noted that the company is “burning roughly $50 million in cash” per day.
Yet the airlines are not alone in their current credit squeeze. S&P has already attributed more than 100 credit rating downgrades to the coronavirus, with industries like real estate and energy also falling victim. In the latter sector, the outbreak has coincided with a price war between OPEC and Russia that has battered crude oil prices; as a result, Fitch downgraded 17 North American energy companies last week, citing “significant credit risk” for those in exploration, production and oil field services.
The Federal Reserve appears to be aware of the pressures facing the corporate credit sector. As part of its unprecedented intervention in the financial markets, the central bank has launched credit facilities designed to pump liquidity into both the primary and secondary corporate bond markets.
But the Fed’s facilities only deal in the market for investment-grade debt—and with more than half of investment-grade bonds carrying the lowest possible rating of BBB, there are fears over what a wave of further downgrades into junk territory could mean for issuers and bondholders alike should economic conditions continue to worsen.
For one, being downgraded to junk status makes it much more difficult and expensive for companies to refinance the outstanding debt on their books. Meanwhile, many institutional investors want little to do with junk-rated bonds; some, such as pension funds, are prohibited from owning them. In turn, junk bonds comprise a significantly smaller share of the corporate bond market than investment-grade debt.
“There’s just not as many buyers out there [for high-yield debt],” according to Kathy Jones, chief fixed income strategist at Charles Schwab’s Schwab Center for Financial Research. In addition to forcing many investors to dump the newly junk-rated debt, an influx of downgrades would “overwhelm the high-yield space and make it difficult for yields to come down,” she notes.
While acknowledging that no company is prepared for the steep decline in revenues now facing airline operators, Jones adds that it has “been apparent for years that these companies were laying on more debt” to a worrying extent.
“Now, the tide has turned, and all of their financing costs are going to be higher,” she says. “That’s going to put more stress on them, their balance sheets, and their earnings.”
And should junk-rated companies be unable to raise the financing they need amid an economic recession, it could send many into default—with repercussions that would ripple across the financial markets.
So far, airlines like Delta appear to be on the front lines of this worrying dynamic. If the economy continues to deteriorate, expect other industries to follow the airlines’ trajectory.
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