When it comes to debt, size doesn't matter anymore

Some investors are fretting that the massive global buildup of debt since the financial crisis a decade ago can’t be sustained. It can, at least for a bit longer -— but only at the risk of a more severe correction in the future. That’s because this particular credit cycle may not be typical. The current expansion is largely policy-driven. Governments and central banks have actively encouraged debt-driven consumption and investment in order to prop up growth. Abundant liquidity, central bank debt purchases, and zero or negative interest rates have allowed surprisingly high levels of debt to be sustained and serviced.

Such policies fundamentally alter the dynamics of credit markets. For example, under negative rates, borrowers can only default if they fail to repay principal, since required interest payments are small or non-existent. As the world has seen in Japan, weakened profitability from negative interest rates discourages banks from trying to collect on bad debts. Instead they count on those negative rates to allow zombie companies to continue operating. Emerging signs of debt distress — including deteriorating credit quality and a weakened ability to service debts, as well as a growing number of problem loans — may thus be less worrying than otherwise.

At the same time, a less-appreciated shift in credit markets should be setting off alarms. Since 2008, banks have become less important as providers of debt. This reflects increased capital charges, lower leverage and consolidation within the banking sector. Investors have replaced them — not just traditional debt providers such as insurance companies and pension funds, but newer participants including mutual funds, exchange-traded funds or ETFs, hedge or private credit funds and foreign investors.
 

ETF holdings of corporate bonds, for instance, have doubled since 2009 to around 20 per cent of outstandings. The banks’ share of US leveraged loans has shrunk to around 8 per cent, whereas collateralised loan obliga­tions, managed by specialist fund managers, have increased to 60 per cent of total iss­u­ance. Foreign investors now hold around 30 per cent of the US corporate bond market.

This increased participation of investors in debt markets threatens to worsen any downturn. For one thing, investors typically have little or no capital to cushion losses. Unlike in cases where a bank is the lender, losses will immediately pass through to ultimate investors. This will accelerate the im­pact of any deterioration in credit conditions.

Moreover, many investment funds operate with an asset-liability mismatch. Investors can redeem on short notice but fund assets usually include a portfolio of longer-dated securities. The problem is exacerbated because the search for yield has encouraged funds to invest in riskier and less-liquid assets which they may not be able to realize fast enough to meet redemptions.

A further problem arises where investments are leveraged. If asset values decline, funds may be forced to sell long-term, often illiquid assets to meet margin calls. And they generally have limited liquidity reserves to draw on instead; unlike banks, they can’t access lender of last resort facilities.

Investors, too, typically follow rule-based strategies. A rating downgrade beyond specified thresholds or a large price decline will often necessitate liquidation or affect fund operation. The bulk of corporate debt is now on the border between investment grade and non-investment grade. The outstanding stock of BBB-rated bonds has quadrupled since 2009. Any downgrade would result in forced selling as investors limited to investment grade would need to exit. Banks, which generally hold loans on a hold-to-maturity basis, are less affected by such changes.

Finally, investors are poorly equipped to deal with financial distress. Banks can work with borrowers, restructure commitments or convert loans to equity to minimise losses. By contrast, most investors would be forced to sell holdings, sometimes at prices below true value. The problem is that in any future credit downturn, the hand brakes that banks can apply will have less impact than ever before. This will increase volatility and intensify any developing financial crisis.

To address an evaporation of investor demand and potential forced selling, policymakers would have to increase their intervention in markets by mandating minimum capital and liquidity reserves, similar to those applicable to banks, for these vehicles. If they didn’t, then they’d risk having to use public funds to bail out investors to prevent a major financial crisis. The dilemma illustrates a fundamental aspect of markets: Risk never disappears, it just moves to the least-regulated corner it can find.

© Bloomberg