A decade on from the financial crisis there are good reasons to think that the next one will stem from weaknesses in corporate debt structures, writes Brian Caplen.

Governments have mostly resisted calls by economists to benefit from low interest rates and increase borrowing. In contrast, companies have taken full advantage of cheap money to load up on debt to the extent that they now look highly exposed in a very uncertain geopolitical and economic environment.

There are two big concerns: leveraged loans and triple-B bonds. A report by the Financial Stability Board (FSB) last December raised red flags over leveraged loans as well as their securitisation into collateralised loan obligations or CLOs.

The FSB report notes that CLO issuance, which virtually stopped immediately after the financial crisis, exceeded pre-crisis levels in 2014 and has stayed strong ever since. Banks have large exposures to both leveraged loans and CLOs and “these exposures are concentrated among a limited number of large global banks and have a significant cross-border dimension”.

Non-bank investors such as insurance companies and investment funds also have exposure to the sector, says the FSB, but data gaps – for example, on the indirect linkages between banks and non-banks – make a comprehensive assessment of the systemic implications difficult.

Banks are less directly exposed to the vast quantities of triple-B bonds issued by corporates, but these still have potential to cause market turmoil. At its Credit Outlook 2020, Fitch presented a chart (see below) showing how the triple-B share of the total investment-grade corporate bond market in EMEA by number of issuers has risen from just over 50% 10 years ago to around 70% now. The same broad trend is observable in the US.

Looking across the US and European markets, Fitch estimates that between $105bn and $215bn (out of a $5 trillion total investment-grade corporate bond market) could be expected to migrate to BB, and therefore become high-yield, in a downturn.

This would not by itself cause a problem but with many investment-grade investors prohibited from holding high-yield bonds, it’s easy to see how it could unleash a wave of panic selling in the triple-B sector. 

With the global trade situation still tense, the corporate bonds of manufacturers and exporters are likely to be the most vulnerable to a downgrade. Time maybe for regulators to worry less about banks and more about companies.

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Brian Caplen is the editor of The Banker. Follow him on Twitter @BrianCaplen

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