The market is finally waking up to the prospects of not just viral contagion from coronavirus, but also to financial and geopolitical contagion. Now the contagion is spreading rapidly into the credit markets where not only energy bonds are plunging but other sectors like airlines, lodging, and retail are sure to follow suit. Then there is the knock-on effect to corporate earnings and cash flows across a broad swath of industries once the world enters a global recession which now appears to be inevitable. We
The market is waking up to not just the viral contagion of coronavirus, but also to financial, economic, and geopolitical contagion.
by Scott Minerd, Guggenheim Partners
arrive at this moment with the overleveraged corporate sector about to face the prospect that new-issue bond markets may seize up, as they did last week, and that even seemingly sound companies will find credit expensive or difficult to obtain. Credit spreads have a long way to expand. BBB bonds could easily reach a spread of 400 basis points over Treasurys while high yield would follow suit with BB bonds at 750 basis points over and single B bonds at 1,100 basis points over. The risk is that it could be worse. As for stocks, technical analysis suggests that there should be support around 2,600 on the S&P 500, but in a recession scenario a level closer to 2,000 could be the ultimate outcome.
by R. Scott Richardson, JD, CLU, ChFC Founder & CEO IZALE Financial Group
The only silver lining is that you should have some gains in the bond portfolio. But now what? Unless you have a robust loan pipeline, where do you go with maturing bonds or to invest the cash from loan payments?
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Ultimately, investors will awaken to the rising tide of defaults and downgrades.
By Scott Minerd, Global CIO Guggenheim Partners
And let’s not forget downgrade risk of BBBs: today 50 percent of the investment-grade market is rated BBB, and in 2007 it was 35 percent. More specifically, about 8 percent of the investment-grade market was BBB- in 2007 and today it is 15 percent. It has more than quintupled in size outstanding, from $800 billion to $3.3 trillion. We expect 15–20 percent of BBBs to get downgraded to high yield in the next downgrade wave: This would equate to $500–660 billion and be the largest fallen angel volume on record—and would also swamp the high yield market.
Ultimately, we will reach a tipping point when investors will awaken to the rising tide of defaults and downgrades. The timing is hard to predict but this reminds me a lot of the lead-up to the 2001 and 2002 recession.
The prolonged period of tight credit spreads experienced in the late 1990s lulled investors into unwittingly increasing risk at a time they should have been upgrading their portfolios.
This brings to mind the famous observation by economist Hyman Minsky, who stated that stability is inherently destabilizing. That is to say that long periods of relative stability in risk assets causes investors to keep upping the risk during a long period of calm.
Ultimately, this leads to what he called a Ponzi Market where the only reason investors keep adding to risk is the fear that prices will be higher tomorrow (or in the case of bonds, yields will be lower tomorrow).
Daniel Kahneman observed this behavior in his own work, when he identified that investors’ fear of missing an opportunity induces them to buy when they should be selling.
Even though the recession clearly has been put off until 2021 and perhaps 2022, in the lead-up to the 2001 recession, credit deterioration started to be evidenced three years earlier in 1998 as defaults and credit spreads were rising.
This would sound like good news for yield starved investors and I would agree.
But patience will lead to bigger opportunities for disciplined investors who don't wander off into exotic asset classes or chase current returns.
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At well-capitalized institutions, examiners have been quick to identify funding concentrations in high-rate deposits and to question stress testing assumptions for high-rate deposit run-off and the feasibility of utilizing national market deposits (e.g. Qwickrate, National CD Rateline, etc.) in times of stress. Recently, the FDIC published a Notice of Proposed Rulemaking outlining potential changes to the calculation of the national rate and adjustments in the determining criterion for the rate cap.
Some key highlights from the FDIC's proposal are outlined below:
Taylor Advisors' Take:
While not perfect, we view this proposal from the FDIC as a shift to a more 'common sense' approach in managing the interest rate cap restrictions. This proposal would provide meaningfully more latitude for deposit rates within the national rate cap by using the 95th percentile and simplifies the process by which banks calculate a local market rate cap. While this proposal does not entirely eliminate the liquidity trap posed by interest rate caps, it does go a long way in providing regulatory relief to less than well capitalized institutions and eases liquidity stress testing assumptions for well capitalized banks. Banks have a 60-day window to voice their opinions to the FDIC.
by Diane Franklin, contributing writer for CUES
Consult with a professional advisor about your particular situation.
Are insurance benefits provided to board members considered taxable income? The answer is largely “yes,” but also, “it depends.”
“The general rule under the tax code is something provided in return for services rendered is taxable income to the recipient (board member),” says R. Scott Richardson, JD, CLU, ChFC, president/CEO, IZALE Financial Group, a CUES Supplier member in Elgin, Illinois. “However, insurance benefits can be treated differently.”
Richardson explains that while the value of accident and health insurance is not taxable for employees, it will likely be taxable for board members.
“There are narrow exceptions where it would not be taxable income,” so consulting a tax advisor is worthwhile, he says.
In the case of life insurance, rather than take out a formal policy, credit unions can promise to pay a benefit (out of pocket) upon a board member’s death, in which case the beneficiaries would report the amount as ordinary income. The CU is essentially acting as its own insurance.
However, in the event of a policy paid for by the CU, Richardson reports there is a choice: “Either the board member reports the ‘economic benefit’ of the coverage as income each year, resulting in an income-tax-free benefit, or the board member does not report economic benefit, resulting in a benefit subject to ordinary income taxes.”
Life insurance is generally income-tax free except when someone else pays for it, in which case there’s some “economic benefit” to the board member, he explains. If the board member owns the policy but premiums are paid by the CU, the premiums paid by the CU equal the economic benefit and are taxable income. If the CU owns the policy and allows the board member to designate a beneficiary, then the right to designate the beneficiary is the economic benefit. If the board member reports the value of that economic benefit each year as taxable income, then death proceeds received would be income-tax free. If the board member does not report the value of the economic benefit each year, then death proceeds would be subject to ordinary income tax.
With long-term care insurance, Richardson notes that any benefits received under a qualified policy are not taxable, though the premiums likely would be. “Since board members are not employees, they would be treated as ‘self-employed’ for income-tax purposes.”
Jim Patterson, partner with Minneapolis-based law firm Sherman & Patterson, similarly notes that directors are under different tax rules than employees. “… directors are not subject to some of the tax benefits that employees get,” he said. “In the case of long-term care insurance, for instance, if that were provided to an executive employee of the credit union, it can be done so on a tax-free basis. But for directors, who are not employees, that would be considered taxable income.”
Even if these benefits are taxable, Richardson says there are still advantages for both the board member and the credit union. “First, paying taxes on $1 of reportable income requires much less cash flow than paying the $1 of premium out of pocket. Second, there are pricing discounts and underwriting concessions available to groups that can be the difference between being affordable and attainable versus not.”
Richardson concludes with advice to consult with tax professionals “to understand the full implications.”
Diane Franklin is a freelance writer based in Missouri. This article published with expressed permission from CUES
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