Markets reaction over Covid-19 outbreak – Insight on pandemic and corona bonds

The world economy is falling into recession as the virus outbreak involves more countries, but as the IMF chief economist Gita Gopinath points out, this is not like a normal recession.

This health system crisis and the drastic governments’ actions as the self-isolation and forced quarantine are strongly affecting the global real economy.

These actions have created a global slowdown of the economy and diffuse uncertainty, which will cost the global economy $ 1tn in 2020, according to what discussed during the World Economic Forum. As the real economy faces recession, financial markets crash and report worst performances since the 2008 financial crisis. Central Banks worldwide are taking important actions to try bring a little calm.

On Thursday 19thof March Christine Lagarde, president of the ECB, has launched a new “bazooka”: the PEPP, Pandemic Emergency Purchase Program consisting in €750bn bond-buying, claiming that “Extraordinary times require extraordinary actions”, a “whatever it takes” kind of statement. Similar plans were made by the Federal Reserve, which has pledged to provide a $700bn stimulus package and has brought interest rates close to zero from the 1.50% at the beginning of the year.

Markets reaction

The entire stock market is being heavily hit with European and US equity indices at the top of the black list, following the path of the virus spread. Eurostoxx 50 has lost 33.34% in the last 30 days while the S&P 500 about 24%. It took a breathtaking 19 trading sessions for the Dow to fall by at least 20% from its record high last February, a drop that meets the commonly used definition for a bear market. That’s the fastest such slide from peak to trough since 1931. It took 16 trading days for the S&P 500 from its record peak to enter a bear market, the fastest such reversal since 1933. The Nasdaq Composite Index also slid into a bear market in those 16 days, the fastest such decline on record. The pummeling would have been even worse if not for several robust, although short-lived, rallies that were fueled by hopes that the government might come up with a financial antidote that would prevent the fallout from the coronavirus outbreak from becoming as bad as it is now.

The industries which had the worst losses have been Oil & Gas Production, Hotel and Tourism, Airlines. The latter was strongly hit with a -62%. Giants like Ryanair and Delta Airlines have been forced to stop almost 100% of their flights due to cross-border bans and planes workload close to 0% due to quarantine and have dropped by 46% and 63% respectively in the last 30 days. Another huge fall is the one of the cruises industry with Carnival Corporation (the world’s biggest cruises company) which has lost more than 70% of its market value in the last few weeks.

On the commodities side, oil prices fell to below $25 per barrel on Friday. Brent and U.S. crude have both collapsed about 40% in the past two weeks weighed by the spread of the virus causing huge decrease in demand due to the low level of consumption and the collapse of coordinated output cuts by producers from the Organization of the Petroleum Exporting Countries (OPEC) and others including Russia. Big Oil & Gas stocks like Exxon in the US and Eni in Europe are facing huge losses, almost halving their market value in the last month.

This week, gold fell from $1,590 to $1,455 before recovering around $1,500. The fall is approximately 8.4 in percentage terms, which is very high compared to average weekly movements. The coronavirus has increased volatility in all asset classes with the equity class’s daily movement of 6% being common nowadays. Precious metals too have seen massive intraday movements and virus-related panic have forced investors to raise cash by selling gold and silver. This situation should not be surprising: investors should look at the history of 2008 crash where the same situation was playing out. In the mad dash to raise cash, sometimes even the safest of safe-haven assets get liquidated. During the heightened crisis of 2008 credit crunch, gold was getting liquidated along with S&P 500 but in Oct-Nov, gold prices started bottoming out in spite of S&P 500 still declining. Once the worst part of panic subsided, gold commenced a new bull market which eventually led prices to all time high.

On the currencies side, must be noticed the unprecedented 4% fall of the British Pound in violent trading week. The UK currency hit a low of $1.1463, having closed the previous day at $1.2050. The dollar extended its gains on Wednesday and hit new multi-year highs against both the Australian and New Zealand dollars, as companies and investors worried by the coronavirus outbreak rushed to the world’s most liquid currency. Markets have crumbled this month as investors liquidated nearly everything for cash driving up the dollar’s value and the cost of borrowing the greenback abroad. The U.S. dollar was last up nearly 0.5% against a basket of currencies, after hitting an almost three-year high in earlier trading on Wednesday. It has gained more than 5% over the past two weeks. Export exposed currencies fared particularly badly versus the greenback. The Australian dollar sank to a fresh 17-year low of $0.59215 on Wednesday, while the New Zealand dollar hit a decade low of $0.5850 cents. Only perceived safe-haven currencies managed to hold their ground against a strengthening greenback with the safe-haven yen up around 0.2% to 107.42 yen while the Swiss franc up by a similar magnitude to $0.9598 francs.

Last but not least, the bond market is living, as the other asset classes, a turbulent and unique moment in its history. US treasury yields have far breached the 1% level threshold falling again on Friday capping off a wild week for the bond market. The yield on the benchmark 10-year Treasury note fell 18 basis points to about 0.93%, while the yield on the 30-year Treasury bond dropped 24 basis points to 1.52%. Bond yields move inversely with prices. On the other side of the ocean instead Germany’s 10-year yield climbed sharply to minus 0.26% at one point, the highest in two months, while UK 10-year gilt yields leapt to 0.7%. The pressure was even more intense in riskier eurozone government bonds. Italy’s 10-year yield surged to 2.78%, the highest in more than a year. In early March, Italy was able to borrow for a decade at roughly 1%.

In this dramatic framework, the good news is that the stock market remains in far better shape than it was during the last financial crisis since the S&P 500 is still nearly worth four times higher than it was at its low point 11 years ago. The bad news is the same government toolbox that helped resuscitate the economy back then may not prove to be a cure for the economic ills caused by the biggest pandemic in a century. While during the financial crisis central banks lowered short-term interest rates (especially the ECB dropped them to 0%) helping to create a virtuous cycle as consumers spent more, this time protecting people’s health is requiring the economy to go into “hibernation” for what could be just a few weeks or could turn into many months until an effective vaccine against COVID-19 is found. After all, consumers can’t spend when they are being ordered to stay home as much as possible.

“Those numbers that in the past would say, ‘OK, you’re definitely at a bottom,’ don’t mean that right now because there hasn’t been evidence that’s taken place,” said Willie Delwiche, an investment strategist at Baird. “It’s extreme markets becoming more extreme, so then your boundaries of what’s extreme need to change with it.”

While the financial world is trying to catch up with this unexpected situation, some debt instruments have been brought to the fore as possible solutions to the crisis and will be discussed in the insight of his article.

Equity indexes performances: S&P 500 (blue), Dow Jones (red), Stoxx 50 (yellow) and FTSE 100 (green)

Pandemic bonds

Very discussed financial instrument during these days is the World Bank’s pandemic bond, a special security designed to make payment to poorer nations whenever a pandemic outbreak reaches certain criteria; countries eligible for payout are 76 countries under the World Bank’s International Development Association.

Pandemic bonds are a particular type of insurance linked securities or catastrophe bonds, also called CAT bonds: they are event-linked debt instruments created by the insurance and reinsurance industry, with the aim of selling insurance risk in capital markets.

CAT bonds are composed of a debt instrument and a call option: if the linked catastrophic event takes place during the life of the instrument, investors lose their principal and interests, while the funds are used by the issuer to pay the arising claims.

The classic structure usually involves the creation of a single purpose reinsurer (SPR), which issues bonds to investors and invests the relative proceeds in short-term securities (government bonds or AAA corporates) held in a trust account. The principal can be partly guaranteed or fully at risk; in the first option the relative tranche is protected, at the occurrence of the event the repayment can be delayed or not completely lost. The majority of CAT bonds, however, are fully at risk: if the event is large enough, the investor loses the whole amount.

To compensate for the risk taken, a premium/higher-than-average coupon is paid to investors, in addition, to immunize from the interest-rate risk, the fixed return on the securities held are swapped for floating return (based on widely accepted interest rate benchmark).

An emission of this kind took place in July 2017, covering six viruses likely to cause a pandemic, including coronavirus. The aim was to provide financial support to the Pandemic Emergency Financing Facility (PEF), created by the World Bank to channel funding to developing countries facing the risk of a pandemic. The emission was in response to the Ebola outbreak in Africa between 2014 and 2016, the goal was to transfer the economic risks of a disease outbreak from under-developed countries to financial markets.

The 5-year note is divided in two tranches for a total size of $320m. Investors are aware and ready for losses, since last week the World Health Organization (WHO) has declared the covid-19 outbreak has reached pandemic proportions. However, some conditions (which differs from tranche to trance) set by the World Bank have to be met: the outbreak needs to last more than 12 weeks and cause more than 2.500 fatalities. In addition, it takes 84 days after the first WHO “situation report” on an epidemic to the funds to be transferred.

Investors holding the riskier tranche, B, are set to lose the full principal of $95m; whereas tranche A investors can lose a maximum of 17 per cent of the total investment, $225m.

The conditions set are very discussed for several reasons: they are considered too stringent, e.g. when the second Ebola outbreak in 2018 killed 2.200 people in the Democratic Republic of Congo, nothing has been transferred because the outbreak didn’t reach 20 death in a second country. A second objection regards timing and it is brought by public health experts who believe that the funds availability will be too little to help poor countries.

Investors who have chosen to buy pandemic bonds were mainly driven by two reasons: they offer a much higher yield than other fixed income products (Class A: 6.5% plus 6-month US dollar Libor rate; Class B: 11,10% plus 6-month US dollar Libor rate). Secondly, this asset class is not linked to stock market performance therefore was seen a good opportunity for diversification; however, DBRS Morningstar cautioned “the current coronavirus outbreak is showing that the valuation of pandemic bonds is highly correlated with the performance of global financial markets when it matters most”.

There is no public information on who precisely the investors are because they were privately placed but they are mostly based in Europe and US.

Corona Bonds

Another very discussed instrument is the coronavirus or simply “corona” bond: the Italian prime Minister Giuseppe Conte has proposed the issuance of corona bonds as a European common response to the difficult economic circumstances the EU is facing.

In fact, the roots of the discussion are to be found in 2011, sovereign debt crisis: when northern European countries, such as Germany, the Netherlands and Austria refused to join their debt with riskier countries, Italy, Greece and Portugal, issuing debt together. However, the current situation appears different as the covid-19 is giving a shock to the entire system and measures need to be more coordinated and consistent to protect the eurozone.

ECB member and governor of the Bank of Portugal, Carlos Costa, suggests a bond issuance characterized by maturity of several decades and the proceeds would only be used to deal with the economic consequences of the virus. Regarding the amount some German economists suggest the joint bond issuance should amount €1tn.

The issuing institution of corona bond has to be a European Institution, that will likely be the European Stability Mechanism (ESM) or the European Investment Bank (EIB).

Coronabonds still need to be fully discussed but given the different circumstances, the arguments used in 2011 no longer regard moral hazard, as the proceeds would be used to cover the spending due to the virus outbreak, affecting the whole region.

Authors: Silvia Monge, Mirko Filice

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