But the danger comes where investors are lulled into a false sense of security, either in the belief markets have already priced in interest rate risk, or because their risk models or assumptions are leading them down a riskier path than is likely to reflect reality.
THE DEBT MOUNTAIN
Rapid global re-leveraging is a storm cloud gathering pace.
“Debt is the big issue today and the sensitivity to an increase in interest rates is building quite materially around the world,” Pan Trustees’ Mattingly says.
It has become improbably easy to borrow money in today’s super-low interest rate environment. Perhaps one of the best examples of this is the large-scale willingness of US corporates to finance their share buyback binge through debt, rather than the vast cash reserves they hold on their books.
The debt mountain is perhaps more worrying in emerging markets, where, according to David Stubbs, global strategist at JP Morgan Asset Management, corporates have issued a lot of paper in US dollars, which, he says, “creates a classic emerging market default risk”.
The Bank of International Settlements (BIS) pointed out in a recent paper, entitled Risks related to EME corporate balance sheets: the role of leverage and currency mismatch, the extent to which emerging market corporates have also taken advantage of superlow rates to ‘ramp up their overseas borrowing and leverage’ as the report states. It points to the increasing leverage to earnings ratio of emerging market corporations, which has steadily risen since Q3 2011 and corporate indebtedness now ‘hovers around 100% of GDP for some emerging markets’.
Rising debt to earnings ratios paints a deteriorating picture of those corporations’ ability to meet their obligations. The problem becomes even more exaggerated when the amount of foreign currency borrowing is considered. International debt issuance in particular has increased steadily and rapidly since 2009 when it was just over $50bn to roughly $190bn in 2013.
“There is a currency mismatch in emerging markets, particularly on corporate lending,” according to UBS’s McCallum. “The question is how much borrowing is in dollars when their income is in their local currency? Investors need to consider very carefully where that risk exists as the currency mismatch has often been a big part of emerging market crises in the past.”
Not only does the strong appreciation of the US dollar potentially spell trouble for these companies, especially where they are commodity exporters and have suffered concurrently from falling prices, if there were a withdrawal of investor demand for emerging market corporate debt, their ability to roll these elevated liabilities could present a very significant problem. BIS data suggests the rollover needs of corporates from major emerging market and their overseas subsidiaries will rise from around $90bn in 2015 to a peak of $130bn in 2017–18.
AMPLIFYING RISKS
So while investors are pilling into riskier assets, in accordance with the desires of central banks, debt is also building across the system. While there are clear risks associated with heightened interest rate and currency sensitivity, this is not the end of the story. All these risks are increasingly bound together through a massive structural decrease in liquidity.
Yoram Lustig, head of UK multi-asset investing at Axa Investment Managers, says: “There are a lot of reasons to be very concerned. The low interest rate environment is pushing retail and institutional investors into riskier assets in search of the yield they are not getting from conservative investments. As they buy more and more risky investments like high yield, emerging market debt or illiquid infrastructure, there is a build up of crowded trades. One risk is liquidity risk. If there is a shock everyone will want to get out, but there will be no buyers, so we could see a repeat of a 2008 scenario.”
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