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Risk averse banking sector could facilitate a snapback in debt markets

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After the fall: Rebuilding in the post-crisis world

S&P Global Market Intelligence takes a look at the lasting impact of the worst global economic crisis since the Great Depression. For a complete list of stories, click here.

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The retrenchment of the banking sector from debt markets in the wake of the global financial crisis has enabled nonbank institutional asset managers to come to the fore, potentially increasing the risk of a major shift in the cost of debt.

The introduction of capital reserve ratios and low interest rates resulted in banks reducing their exposure to risk, allowing other creditors to expand into the market. The International Monetary Fund and the Bank for International Settlements are among the institutions warning that such a structural change to the market has heightened the potential for capital flight in a downturn, draining liquidity from debt markets.

This could be disastrous for highly levered nonfinancial corporates, particularly in the U.S. where declining credit worthiness of companies and a more hawkish Federal Reserve is boosting borrowing costs.

In a recent interview, Claudio Borio, head of the BIS' monetary and economic department, said the biggest concern to the global economy is the buildup of aggregate debt relative to GDP. "Banks have retreated internationally, and now capital markets are the most exposed. Any problems will be seen more in the asset management sector," he said, noting his expectation that emerging market economies will be "at the forefront of what occurs."

Debt, debt and more debt

The total assets of nonbank institutional asset managers are estimated at $160 trillion, according to the BIS, a total that exceeds that of global banks. This group, which includes investment management companies, pension funds and insurers, has grown significantly in the last decade.

Credit has also grown considerably, despite the pullback of banks. Outstanding institutional leveraged loans in the U.S. have almost doubled since 2007 to just below $1 trillion, whereas riskier, outstanding high-yield bonds are worth $1.3 trillion.

Global leveraged loan issuance hit a record high in 2017 of $788 billion, according to the IMF, surpassing the pre-financial crisis high of $762 billion in 2007. Some $564 billion of that comprised loans in the U.S.

The volume of debt due for renewal is increasing rapidly, according to S&P Global Ratings. A total of $11 trillion of corporate debt rated by S&P will mature by the end of 2023 with the rating agency warning U.S. corporates are at greater risk to a snapback in borrowing costs than those in Europe. "While U.S. growth and cash generation are also strong, equity and credit valuations are priced for perfection and the potential for risk-asset repricing is high." In the rating agency's view, there is not yet a crisis, but there is the "potential to become one."

The main threat, says the BIS, is the potential for liquidity to collapse as soon as the market turns and underpriced risk, caused by years of low interest rates and quantitative easing by central banks, is quickly revalued upward.

In its annual economic report, the BIS identified the increasing pressure on pension funds and insurance companies from the rising mark-to-market value of their long-term liabilities. "This has incentivized asset managers to both invest in riskier assets and extend the duration of their portfolio," the BIS wrote, noting that these trends suggest "sensitivity to snapback in both interest rates and [volatility] has increased."

The large number of independent funds present in the debt markets should, in theory, mitigate the risk of concerted trading activity, but "there is evidence that fund families exhibit correlated return and investor flow patterns."

The BIS argues that the presence of insurance companies and pension funds increases the likelihood of concerted selling in a downturn. This is partly because of increasingly similar portfolio holdings, but also due to hedging strategies that could see investors respond to a rise in long-term yields "by selling long-term bonds in order to contain duration mismatches, adding to the risk of abrupt interest rate adjustments."

The growing influence of some passive investment vehicles, particularly exchange-traded funds, in less liquid underlying markets, could also amplify the impact of asset price moves on the financial system.

Investors flee to safety

The heightened geopolitical risks of potential trade wars, currency crises in emerging markets economies and flattening yield curves have already led investors to shift their portfolios toward assets it considers safer, raising concerns about demand for debt in less liquid sectors such as emerging market debt or corporate bonds.

Fitch Ratings warned Aug. 21 that liquidity in Turkey's corporate debt markets is a growing concern and downgraded ratings for local food group Yasar and retailer Migros Ticaret AS. "Turkish corporates, similar to those in some other emerging markets, rely on uncommitted bank credit lines. Although to date, the companies have been able to regularly renew these lines, availability may become more restricted if the currency crisis intensifies further and the impact on Turkish banks intensifies," Tatiana Kordyukova, senior analyst at Fitch Wire, wrote.

Portfolio managers increasingly stress prudence, recommending investments in safe havens rather than chasing yields. Examples include the collapse across the board in emerging market currencies despite few exhibiting the unorthodox fiscal policies seen in Turkey.

Asset management group PIMCO notes that whereas in the last several years it has paid to be long for "just about any asset other than commodities," the Fed's more hawkish policies have changed the picture. "Valuations have become stretched and we should start to see greater dispersion in returns across sectors, regions and factor styles," wrote Mihir Worah, PIMCO's chief investment officer of asset allocation.

Similarly, Adam Bloch, a portfolio manager at Guggenheim Investments, said highly levered triple-B rated bonds are a particular concern and Guggenheim is "recession proofing" its portfolio ahead of a slowdown in economic growth.

S&P Global Ratings and S&P Global Market Intelligence are owned by S&P Global Inc.