Posted inFixed Income

Global regulator concerned at high yield fire sale in downturn

The Bank for International Settlements has warned that investors could be forced into a fire sale of low grade corporate bonds to continue to meet investment grade mandates in the event of a downturn.

The central bank’s central bank, has used its annual economic assessment to point out that since 2000 the share of issuers with the lowest grade of credit has risen from 29% to 36% in the US, but that in Europe it has risen from 14% to 45%.

The report says: “Given widespread investment grade mandates, a further drop in ratings during an economic slowdown could lead investors to shed large amounts of bonds quickly. As mutual funds and other institutional investors have increased their holdings of lower-rated debt, mark-to-market losses could result in fire sales and reduce credit availability.”

The report takes a look at a wide range of risks and their interconnectivity. In relation to credit, it is also concerned about leveraged loans.

It says: “Lending to leveraged firms – i.e. those borrowing in either high-yield bond or leveraged loan markets – has become sizeable. In 2018, leveraged loan issuance amounted to more than half of global publicly disclosed loan issuance loans excluding credit lines.”

BIS is also concerned about how financial conditions respond to how exposed banks are to collateralised loan obligations although the picture here is at least much better for Europe.

While globally, banks originate more than half of CLOs, European banks hold much lower holdings at 10% compared with the US banks at 60% and 30% in Japan.

Not the same risk as pre-financial crisis

The bank does not believe that CLOs represent the same risk to banks as sub-prime loans and various asset backed securities and related instruments did around 2007 and 2008 at least partly due to improved capital and liquidity cushions.

It does however come with a caveat about concentration of risks and broader concerns about the search for yield.

“The concentration of exposures in a small number of banks may result in pockets of vulnerability. CLO-related losses could reveal that the search-for-yield environment has led to an under-pricing and mismanagement of risks. In turn, this could generate dynamics that would bring banks’ direct and indirect exposures to the fore.”

“All else being equal, more vulnerable would be banks that have extended credit lines to leveraged borrowers, have links with asset managers active in the CLO market, find it hard to accumulate loss-absorbing capital (e.g. because of profitability issues), and/or depend on short-term (eg FX swap) funding markets.”

BIS also believes that tightening financial conditions could dampen investment and thus amplify any slowdown. It also leaves countries with higher corporate debt vulnerable to a sharper slowdown.

It also may be having a knock-on effect on commercial property prices.

Among economies with relatively high corporate debt, commercial property prices have declined over the past year in France, Sweden and the United States.

Estimates for a panel of advanced economies suggest that high corporate debt service ratios amplify any slowdown in output growth.

“The continued increase in corporate debt has consequences also for the aggregate productive potential of the economy. Firms that are unable to cover debt servicing costs from operating profits over an extended period and that have muted growth prospects – so-called zombie firms – have been on average 40% more leveraged than their profitable counterparts.”

The issue of debt is not the only concern for BIS. For example, it still has worries about the health of eurozone banks and how last year’s mini loss of confidence affected them.

“In the euro area, the deterioration of the growth outlook was more evident, and so was its adverse impact on an already fragile banking sector. Price-to-book ratios fell further from already depressed levels, reflecting increasing concerns about banks’ health.”

“Unfortunately, bank profitability has been lacklustre. In fact, as measured, for instance, by return-on-assets, average profitability across banks in a number of advanced economies is substantially lower than in the early 2000s. Within this group, US banks have performed considerably better than those in the euro area, the United Kingdom and Japan.

“Looking ahead, depressed market valuations, as reflected for instance in lower price-to-book ratios, suggest lingering concerns about long-term profitability. Furthermore, the increase in capitalisation has occurred to a large degree owing to slower asset growth. Hence, going forward, weak profitability could potentially constrain credit growth through slower equity accumulation,” it says.

It also suggests that banks could suffer if rates remain low and growth also declined.

“Both macroeconomic and banking-specific factors have sapped bank profitability. On the macro side, persistently low interest rates and low growth reduce profits. Compressed term premia depress banks’ interest rate margins from maturity transformation. Low growth curtails new loans and increases the share of non-performing ones. Therefore, should growth decline and interest rates continue to remain low following the pause in monetary policy normalisation, banks’ profitability could come under further pressure.”

Part of the Bonhill Group.