Fixed income investors have had a busy start of the year with heavy new issuance coming to the market. These new flows contribute to the global debt level which is already historically high and shows little signs of declining. In this article, we assess the role of easing monetary conditions, and discuss how financing decisions of fixed income issuers are affected by the prolonged period of low rates.
Debates around rising global debt are not new. Some claim that increasing global debt is a significant risk and can cause a new financial crisis, while others say that lending is an important part of stable economic growth and with favorable conditions for debt servicing, high leverage is not necessarily harmful. Both views are legitimate and have proven themselves in the past. Although risky by nature, high global debt in itself is not enough to spur a recession, but it can be a big piece of the puzzle if the global economy slumps.
Figure 1. Debt securities outstanding per issuers in developed countries and emerging markets, billions USD. The leverage is higher than it was before the financial crisis 2008-2009. Source: Bank of International Settlements.
The current environment of persistently low yields is seen by many as a favorable moment to borrow money. Easing policies by central banks make borrowing attractive and companies are increasingly issuing new debt in an attempt to benefit from the low yield environment. In January, the European bond market hit a record in primary deals with new issues close to €240 billion. Governments and companies from around the world, rated as both investment grade and high yield, come to Europe to secure new low-cost debt at a time when the deposit rate of the European Central Bank (ECB) is set at a record low of -0.50%. Notably, this extensive bond supply is welcomed by high demand from investors who continue to buy fixed income instruments even with low yields as there are few alternatives unless they are willing to move to more risky or illiquid strategies.
There is an enormous amount of liquidity in the market prompted by easing monetary policy. Out of 38 central banks monitored by the Bank of International Settlements, 22 delivered rate cuts in 2019. Additionally, major central banks in the world keep increasing their balance sheets as a result of quantitative easing (QE) programs. The ECB has restarted the asset purchasing program in November 2019, while in the US the Fed had to come up with supportive measures for a distorted repo market in September 2019, effectively re-introducing a form of QE on the front end of the curve. The massive buying by central banks is assisting in absorbing the large new issuance of bonds and supporting further growth of the debt levels.
Figure 2. Dynamic of the asset purchasing programs by central banks in the largest economies (by GDP). Represented by the size of total assets on the balance sheet (billions, USD). Source: Bloomberg.
While cash injections into the financial markets are supposed to boost economic expansion, economic growth forecasts keep being revised downwards. There is a mounting concern that the stimulus introduced by these monetary policies has side effects that not only limit the support to the economy but also impact the behavior of market participants. To have a robust asset allocation, long-term investors should be aware of how the trend of increasing global debt amid ample liquidity impacts the financing decisions of issuers and what the potential pitfalls from a credit risk perspective are.
Government debt flows
Governments represent a large piece of bond issuance as many of them constantly use financial markets to borrow and thus finance their budget deficits. The ability to repay debt by a sovereign is supported by the fact that governments are responsible for tax collection and government spending and so have powerful tools at their discretion which can save them from default on their obligations. Economically healthy countries with sustainable institutions and prudent governance are considered issuers with low credit risk. Notably, some countries have a strong credit outlook are perceived as low-risk issuers despite their high level of debt.
Figure 3. Distribution of countries with respect to their credit rating and general government debt as % of GDP. The size of the bubble increases with a higher debt level. Source: Bloomberg, Fitch, OECD.
The US stands out since its level of debt is extremely high for an AAA-rated country. Moreover, US government bonds are deemed safe-haven assets even though the national budget shows a skyrocketing deficit. This indicates that the credit rating of a sovereign issuer can tolerate significant leverage since governments have exclusive safety cushions. In case of market turbulence, overweighting investment-grade government bonds is the most straightforward asset allocation decision.
Recent auctions by Italy and Greece, countries with excessive levels of debts, attracted a surprisingly high demand for their newly issued bonds. The periphery countries, which were unloved by investors after the sovereign debt crisis, demonstrated how leveraged governments can benefit from low rates and extensive asset purchasing programs. Political uncertainty in Italy and the below investment-grade rating of Greece mean little to investors hunting for yield. Even the most conservative players consider investing in lower-quality sovereigns as long as these countries offer higher yields and have enough mechanisms to sustain their debt.
Corporate issuers and buybacks
In the period after the financial crisis of 2008, many companies were eager to benefit from the recovery of the economy. Thanks to the unconventional tools of central banks, corporates managed to obtain cheap debt, and since rates continued to be unprecedentedly low, they kept borrowing money. Equity investors supported the move, as easing monetary conditions continue to be one of the main drivers for stock markets.
Another important catalyst for equity returns was the enormous amount of buybacks of free-floating stocks by corporates. In the low rate environment, some issuers prefer to take more leverage to buy back equities from the market aiming to reduce their weighted average cost of capital. As a result, stock prices get generous support from the demand provided by corporate repurchase programs, which was one of the reasons for equity markets to reach record highs.
Normally, increasing debt for buyback purposes damages the cash position of a company and leads to a lower credit rating, since a company has less ammunition for a potential downturn. However, in the current environment interest payments are much lower than in the past, so credit agencies seem to have higher tolerance towards leveraged companies.
A vigilant approach
By introducing an extraordinarily loose monetary policy for a long time, central banks might not only drive global debts to unsustainable levels but also change the behavior of market participants. Many risks are kept subdued while the economy is still expanding, the labor market is strong, and investors have a positive outlook. However, in case of a potential downturn, some of these risks can materialize and lead to increased defaults and low recovery rates. The increasing borrowing by companies and governments makes vigilant credit analysis even more important for investment decisions. Every time the market becomes too optimistic, investors should be cautious since, as history showed, bull markets "die on euphoria".