Investors could drive global debt crisis

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 percent of outstandings. The banks’ share of US leveraged loans has shrunk to around 8 percent, whereas collateralised loan obligations, managed by specialist fund managers, have increased to 60 percent of total issuance. Foreign investors now hold around 30 percent of the US corporate bond market.
This increased participation of investors in debt markets threatens to wo-rsen 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 realise fast enough to meet redemptions.
A further problem arises where investments are leve-raged. If asset values decl-ine, funds may be forced to sell long-term, often illiquid assets to meet margin calls. And they generally have limited liquidity reserves to dr-aw on instead; unlike banks, they can’t access lender of last resort facilities.
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.

—Bloomberg

Satyajit Das is a former banker, whom Bloomberg named one of the world’s 50 most influential financial figures in 2014.