There Are No More High-Speed Collisions, Only ‘Parking Accidents’

There’s considerable debate in the market about the extent to which the concentration of leverage in the corporate sector poses a systemic risk. Maybe you noticed.

Post-crisis monetary policy has, among other things, incentivized corporate debt issuance. Borrowing costs are artificially suppressed and thanks to ultra-low yields across safe haven government bonds, appetite for riskier debt (i.e., demand for anything that offers any semblance of yield) has increased. Of course with voracious demand comes tighter spreads, which in turn incentives investors to chase even further down the quality ladder in the quest for yield, until, eventually, everything is priced to perfection.

The question, then, is whether corporate debt will play a role in exacerbating the next downturn or, if you’re the type who likes hyperbole, whether a credit crunch when the cycle turns may ultimately become systemic, triggering a crisis.

One thing we do know, is that thanks in part to the post-crisis regulatory regime, there is a glaring disconnect between the street’s capacity/willingness to lend its balance sheet in a pinch and the size of the corporate bond market.

“The US corporate bond market has near tripled in size since the GFC due to QE, lower yields encouraging companies to issue and high demand for fixed income and spread product, thus providing a captive pool of capital”, Deutsche Bank’s Jim Reid wrote earlier this month, adding that “meanwhile, regulation has ensured dealers/market-makers have less and less ability to warehouse risk.”

(Deutsche Bank)

That disconnect could become a problem at some point, especially considering liquidity mismatches in certain popular retail credit products.

There are other pressing concerns for credit that are tangentially related, not the least of which is the “BBB apocalypse”/”fallen angel risk” discussion. This was all the rage in Q4 and it’s certain to make headlines again the next time spreads start to widen and the cycle looks like it might be turning.

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All of that might sound precarious or scary, but remember, there a number of mitigating factors at play. Corporate profits are healthy and it seems entirely likely that real yields will remain low for the foreseeable future which should, in theory, keep defaults in check.

That doesn’t mean the liquidity mismatch illustrated in the top pane above and the rather ominous decline in turnover won’t ultimately translate to some kind of nightmarish episode of spread widening at some point, it just means that outside of a deep recession, defaults appear poised to remain structurally depressed. You can read more on that here.

Panning out, it’s important to note that all of this sits within a broader discussion around the redistribution of leverage, something Deutsche Bank’s Aleksandar Kocic and Stuart Sparks explore at length in a new special report, which begins with the following simple recap of what happens when volatility is low:

During periods of low volatility, investors have sought to enhance returns via carry strategies. These include allocations to high yield, investment grade credit, emerging markets, and other fixed income asset classes in addition to strategies involving the monetization of the premium of implied over delivered volatility. Such strategies seek to capture carry, at the potential risk that adverse mark-to-market could partly or entirely consume accrued carry profits, and potentially in short periods of time. Demand for carry strategies in low volatility environments put downward pressure on risk asset spreads and implied volatility relative to realized volatility. Tighter spreads, coupled with apparently stable market conditions, induced investors to attempt to maintain returns via increasing use of leverage. That is, narrower spreads have driven investors to increase position size in order to maintain levels of returns.

Ok, now have a look at the following visual, which is just rates vol. versus financials (the right-hand side is inverted).

(Deutsche Bank)

The key point (in case it isn’t obvious), is that the previously tight relationship broke down after the crisis and it’s not exactly a mystery why. Hint: Note how we mentioned the post-crisis regulatory environment above.

“While market volatility declined to ultimately beyond pre-crisis levels, financial equities recovered more slowly, precisely because higher capital requirements and more constraining regulation reduced the available leverage that could be deployed to capture carry in a low volatility environment”, Kocic and Sparks go on to write.

Those capital requirements, and the strictures of post-crisis regulations more generally, have led to deleveraging in the financial sector. Households have deleveraged as well. Of course the public sector and the non-financial corporate sector took the baton, with debt for the former rising to more than 100% of GDP. Here is the juxtaposition between financial sector and non-fin business sector leverage:

(Deutsche Bank)

“The rationale of this maneuver was that, when it comes to credit risk, corporate sector is more transparent than the combination of households and financial sectors together”, Kocic wrote Friday, in a separate note, adding that “by re-syphoning leverage from financials and households to corporates and government, risk has been made less systemic and the margin of error in assessing and monitoring the aggregate credit risk and its misrepresentations in the markets have been reduced.”

Or at least that’s the idea – fingers crossed – etc.

For Kocic and Sparks, the redistribution of leverage should make things safer by effectively limiting the scope for catastrophes. As they put it, “there are no longer casualties of big ‘collisions’, only parking accidents.”

There are two caveats to this, both of which are important.

The first will be familiar to regular readers. It is possible that a wind-down of QE and an eventual rolling back of ZIRP and NIRP exposes an over-leveraged corporate sector to the risk of a disorderly repricing or, worse, a scenario where risky borrowers can’t fund. To wit, from the note:

One of the concerns about the end of QE was the potential adverse impact of less attractive financing conditions on the “marginal” borrower. Even with the partial unwind of the Fed’s SOMA portfolio, zero interest rates in Europe and Japan coupled with ongoing QE in Japan continue to drive capital abroad in the search for yield. The likely hope of policymakers was that by the time central banks exited extraordinary accommodation, economic growth would be strong enough to offset potential externalities of the loss of artificially cheap funding. One important potential source of risk is that this “stasis” does not materialize. It is possible that tightening financial conditions could have the Darwinian effect of making funding materially more expensive for the (riskiest) borrowers that need it most.

One thing you might consider when you read the latter part of that is whether the ECB’s decision to launch another round TLTROs is an effort to head off just such an eventuality – that is, a situation where the end of cheap financing doesn’t appear set to line up with economic stability.

In any case, this obviously conjures the “BBB apocalypse” story mentioned here at the outset. There are serious questions as to whether large capital structures could fund in the HY market and in any case, the potential displacement that would ensue from a downgrade wave that sees a mass migration from BBB to junk is daunting to consider.

BBB issuance was some $450 billion last year and looks set to top $600 billion in 2019 at the current run rate. The following visual is pretty poignant (read: disconcerting, if you’re the type who’s inclined to fret):

(Deutsche Bank)

After reminding everyone that BBBs comprise some 50% of the Bloomberg Barclays US Corporate Bond Index (~$2.6 trillion), Kocic and Sparks caution that the concentration of risk inherent in that gargantuan figure could become problematic in a recession scenario, especially as downgrades would mean IG investors would be forced out of those credits.

And that’s to say nothing of the mechanical/technical challenge posed by HY potentially having to absorb some of these borrowers in an adverse scenario.

“The BBB component of the Bloomberg Barclays US Corporate Index alone is larger than the entire Global High Yield Index, and as such ‘crossover’ downgrades could be expected to materially re-price the HY market as well with clear knock-on implications for equities and core rates markets”, Deutsche goes on to write.

So that’s the first caveat to the thesis that the redistribution of leverage in the post-crisis world makes things less prone to high-speed accidents.

The second caveat is that the impaired capacity of the financial sector to deploy leverage and otherwise take risks has the potential to lead to slower growth in an economy that has become thoroughly financialized. Things are ostensibly “safer” in the new paradigm, but at the same time, it’s possible that the shackling of the financial sector is hobbling the economy. If you want the theatrical Cliffs Notes version of that, see Will Emerson’s (Paul Bettany) famous Aston Martin chat with Seth (Penn Badgley).

The overarching message from all of the above is that when you think about corporate leverage and whether it poses a systemic risk, it’s important to consider how leverage has been redistributed post-crisis.

The argument is that shifting leverage to the public sector and non-fin. corporates is preferable to a setup characterized by over-extended households and a highly-levered financial sector. In turn, the chances of high-speed collisions have been reduced, and the world has transformed into a parking garage where the worst thing that can happen is inadvertently backing into someone at 5mph.

I mean, there are other bad things that happen in parking lots, but that doesn’t seem germane here.