Finance & Accounting Jun 24, 2020
How to Secure Credit During a Financial Crisis
The key? Don’t tap your best collateral in good times.
This spring, as the number of COVID-19 cases in the United States grew exponentially and the economy came to a scratching grind, the corporate bond market was booming.
Issuance of corporate bonds totaled $245 billion in March, compared to $139 billion a year earlier. In April, that number jumped to $316 billion. In the first five months of 2020—as firms attempted to bridge sharp drops in revenue with borrowing—total issuance of corporate bonds amounted to more than a trillion dollars.
But plenty of firms were unable to borrow their way out of harrowing revenue drops. And, as a new research paper shows, these companies have experienced larger stock-price drops during the COVID-19 crisis.
“So desperate was United to raise additional funding that it had to raise $500 million by securing liens on certain airplane spare parts.”
So how can firms prepare in good times so that they will be able to tap into capital markets in bad times?
At one level, the answer is straightforward: maintain financial flexibility by keeping low leverage and a high credit rating. But that is easier said than done. After all, to do so, firms may have to curb their growth and forgo business opportunities.
Thankfully, there is another very important aspect of financial flexibility that firms can manage: avoid secured debt when possible. For firms, pledging assets up front as collateral for secured debt limits their ability to pledge these assets when they need them most—such as during a financial crisis or global pandemic.
In a recent study we found that most companies in the U.S. are issuing secured debt countercyclically and are more willing or compelled to issue it in the trough rather than the peak of a cycle. Borrowers do not seem to want to lose their financial flexibility by pledging assets in good times. Instead, they use security only when necessary—when a firm approaches distress or during the down phase of a cycle, thus accounting for the countercyclicality of secured debt issuance.
The idea that untapped collateral could offer firms financial flexibility during times of crisis is not new: it is even an important factor in some credit-rating models. For example, Moody’s has pointed out that “properties that are free and clear of mortgages are sources of alternative liquidity via the issuance of property-specific mortgage debt, or even sales”—and in fact assigns a lower credit score to firms with higher ratios of secured debt to gross assets.
Yet time and again companies tap their collateral when times are good—and suffer for it. Consider United Airlines, which ended 2019 with 88.5 percent of its $14 billion long-term debt secured by liens of its newer aircraft. When the COVID-19 crisis hit, United rushed to raise additional funding. With a below-investment-grade credit rating of BB-, United was unable to borrow unsecured. So it tried to borrow through a term loan secured by liens on its older aircraft. So desperate was United to raise additional funding that it had to raise $500 million by securing liens on certain airplane spare parts they owned and another $250 million secured by spare engines. When United attempted to raise new funds in early May, its $2.25 billion offering failed when investors deemed the collateral too old and invaluable—United had very little collateral capacity left.
Contrast that with Delta Airlines, which by the end of 2019 had less than 50 percent of its $10 billion long-term debt secured by assets. When the crisis began, Delta was able to issue a $1 billion bond secured by five Airbus A321 aircraft, 22 Boeing 737 aircraft, and six Airbus A330 aircraft valued at $1.47 billion. And Delta was also able to issue an unsecured bond and raise an additional $1.25 billion in late May.
Interestingly, many of the bonds issued in the last three months have been unsecured. But these bonds were issued by firms with investment-grade ratings, such as Disney ($11 billion) or Boeing ($25 billion). For firms with lower credit ratings, oftentimes the only reasonable option is to resort to secured borrowing. Only $37 billion of high-yield bonds was issued in May 2020 compared to $265 billion by investment-grade firms. And those high-yield bonds are much more likely to be secured by assets than the investment-grade bonds.
So the lesson for corporations is clear. Avoid secured debt in good times in order to maintain collateral capacity and financial flexibility. Keep your assets unencumbered—you may need them when the next crisis hits.
Editor’s note: This article originally appeared in Forbes.
Efraim Benmelech, Nitish Kumar, and Raghuram Rajan. 2019. The Decline of Secured Debt. Working paper.
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