Junk bonds: Market anomalies could lead to financial chaos
Companies issue bonds to raise funds. The people and institutions that buy them get paid back their original investment plus interest payments by the time the bonds reach maturity.
Some companies have low credit ratings, as a result, for example, of being heavily indebted or having a poor history of paying back debt. In order to issue bonds, such firms have to offer higher interest on their loans to compensate for the added risk investors must take on. Their securities receive low credit ratings and are called "junk bonds."
Yet recently, their investors have been seeing lower returns. Indices on both global and US junk bond yields have hit record lows, at below 4%. This shows the high level of demand for junk bonds. That's because yields on bonds decline as prices rise; the two have an inverse relationship.
Despite the fall in reward, many investors are willing to take the extra risk. Even junk bonds from a recently bankrupt firm saw heated demand. US department store Neiman Marcus in March issued bonds with yields over 7% just half a year after exiting from Chapter 11. The struggling firm managed to raise 1.1 billion dollars, 10% more than planned, from yield-hungry investors.
Shirota Jun, an expert on financial assets and Professor at Komazawa University, says junk bonds are popular thanks to current monetary policy. "Central banks around the world have kept their policies loose for quite a while, and they've eased further during the pandemic to support the economy. That has led to interest rates on most financial assets falling to near zero or even lower."
Kiuchi Takahide, Executive Economist at Nomura Research Institute and former Bank of Japan policymaker, is concerned about a mismatch between prices and returns. "Prices of high-yield assets are rising and rates are falling to an extent that their levels do not match the risks. There are examples of mispricing in the markets – high yield assets such as junk bonds are being overbought. Where there's mispricing, financial chaos tends to follow."
He adds that junk-bond volumes increased during the pandemic. "Many investors have been trying to get the highest yields they can without taking too much risk, so corporate bonds at the lowest investment grade of BBB have been immensely popular for a couple of years. However, the last year or so has seen economic growth slow, and so their ratings were downgraded to junk levels such as BB. Such assets are called 'fallen angel bonds,' and their values are drastically less than before the downgrades." The quantity of junk bonds has increased in this way while many investors saw the value of their assets fall amid the pandemic.
The Bank of England is worried about the ballooning market of junk bonds. In its Financial Stability Report released in July, it warns that overvalued assets could experience a sharp fall in prices, raising the cost of issuing bonds for companies and harming their fund-raising abilities. That chain reaction could be amplified as it ripples throughout the economy.
Leveraged loans: Ominous aftereffects for lenders
Another type of corporate debt is loans. Firms use them to finance themselves, but in this case, by borrowing from financial institutions. The risky version of this is "leveraged loans," which offer higher yields at higher risk, much like junk bonds.
The leveraged-loan market is rapidly expanding. Institutional issuance in the US for the first quarter of this year grossed 308 billion dollars, according to Fitch Ratings. That's triple the amount than in the previous quarter and significantly above the preceding high of 202 billion marked the same time last year.
Banks, whose profits are being hurt by low interest rates, are actively lending. The situation echoes that of junk bonds: in both markets, ultra-loose monetary policy is leading to an increase in high-risk corporate debt.
The situation may have ominous aftereffects. Financial institutions are being prompted to take on excessive risks because they are desperate for profitable investments. The arrangement leaves them extremely vulnerable, Shirota believes. "When making financing agreements, the lender and the buyer agree to rules called covenants. There are two types: maintenance covenants and incurrence covenants. The former requires routine checks. The latter is laxer, having fewer restrictions on the borrower and fewer protections for the lender. 80% of leveraged loans only have incurrence covenants. That means banks are in a tricky situation. Should something trigger a market crash, a large number of leveraged loans could default, and banks could be hit big time."
Regulators recognize the potential danger. The European Central Bank became the latest to point to excessive risks in the leveraged-loan market. Its Chairman of the Supervisory Board, Andrea Enria, said in a speech in July that the central bank would crack down on riskier lending. Leveraged finance, he said, can expect a tougher stance from regulators. That could include requiring certain banks to raise their required capital ratios.
CLOs: Echoes of the global financial crisis
The ECB's worries aren't limited to leveraged loans. Financial products which are created based on these loans are another concern. Banks are pooling and securitizing these loans into "collateralized loan obligations" (CLOs). Like the loans they're based on, CLOs offer investors high yields. The market has been ballooning globally, nearing the one-trillion-dollar milestone, according to JPMorgan Chase & Co.
Most CLOs contain over a hundred leveraged loans, so assessing their risk can be difficult. These products should sound familiar to anyone who followed the global financial crisis. They are quite similar to "collateralized debt obligations" (CDOs), in which US subprime mortgage loans were pooled and securitized. Subprime loans and CDOs were the cause of the 2008 meltdown. Important to note, though, is that CDOs were pooled and securitized numerous times, making them more complex than CLOs, which only endure the process once.
How CLOs are rated is another cause for concern. Most leveraged loans are rated as below investment grade, at BB or B... but once they're packaged into CLOs, over 60% are given the safest rating of AAA. The simple task of combining them raises their assessment on the premise that it leads to risk diversification. However, Shirota doesn't see things that way. "Of the estimated 3,000 leveraged loans that are securitized, just 250 account for half of the total value of all CLOs," he says. Many banks have large holdings of CLOs, so in effect, they own the major leveraged loans – which are rated at less than investment grade – packaged in the products.
Many financial institutions, especially those in Japan and the US, own large holdings of CLOs because they find the high yields attractive. Japan’s Norinchukin Bank had 62.7 billion dollars’ worth of CLOs as of March this year, by far the most in the world. It is followed by US bank Citigroup at 26.0 billion dollars, then by Japanese banks Mitsubishi UFJ Financial Group at 21.8 billion dollars and Japan Post Bank at 18.5 billion dollars. Meanwhile, in terms of risk level, the Japanese banks assert their CLOs are only of the safest AAA tranche. US bank Wells Fargo states 99% of its holdings are above the AA- grade. US banks Citigroup and JPMorgan Chase say they do not disclose such information but experts believe their tranches are unlikely to be of safer categories.
Kiuchi believes the risk to Japanese banks is minimal. "It would take a lot to trigger a default in CLOs with high ratings, unlike those in lower tranches. Their value may fall, but since most Japanese banks hold CLOs to maturity, the risk they'll lose money is very small." The Bank of Japan and the country's Financial Services Agency shared a similar view in a review published in June 2020 on leveraged loans and CLOs. Japanese banks are not in danger because their CLO holdings are mostly of the AAA category, the authorities concluded.
However, Shirota is skeptical. He reiterates that the risks are not as diversified as they seem, and adds that the fact that regulators came out with a report on the topic proves they're worried.
Shirota also notes that the coronavirus pandemic has increased the risks for the overall CLO market. "Most of the leveraged loans included in CLOs were issued by firms in industries hit hard by the pandemic, such as airlines and hospitality. They may be among the highest at risk of default if support for them ends as the economy reopens."
Looking ahead: Central bank policies in focus
It's clear that junk bonds, leveraged loans and CLOs have potentially significant risks. What exactly, then, should investors look out for? According to Shirota, the dangers will be compounded in the coming months. "Companies that would have otherwise gone bankrupt have survived due to support measures during the pandemic. However, as economies reopen and stimulus measures end, these firms are going to have financial difficulties. They may not be able to pay back the high interest on their loans. There's a very real possibility of large-scale defaults."
This scenario could worsen if central banks tighten policy, lifting interest rates back to previous levels. Inflation has been surging in the US, reaching levels not seen since 2008. Many market participants speculate that policymakers will tighten should they judge that rising prices are here to stay. Shirota cautions: "Risky assets like junk bonds, leveraged loans and CLOs usually have floating rates. That means that if central banks normalize policy, the businesses borrowing money will have to pay back more interest. This could significantly increase the possibility that the firms with low credit ratings would default."
The dangers surrounding high-risk, high-yield assets seem to be substantial. However, Shirota says that although junk bonds, leveraged loans and CLOs do pose a threat to the global financial system, the situation would not be as bad as the global financial crisis. One reason is that capital adequacy ratios for banks were raised after the crisis. That means the institutions are required to always have more cash on hand than before. Therefore, even if some assets fall through, the institutions are less likely to run dry of funds. Shirota anticipates only "a mini crisis" should the current situation deteriorate.
Kiuchi also doesn't believe banks are shouldering excessive risk. However, he has a darker assessment concerning other institutions. "Should we have defaults in high-risk assets, the biggest losers would likely be nonbanks," he says, citing the results of a stress test by the International Monetary Fund. In a scenario of a price shock similar in size to that of the global financial crisis, the world's hedge funds would lose as much as 41% of their assets based on their exposure to high-risk assets, according to the IMF's Global Financial Stability Report. Mutual funds and ETFs would follow with 39% and asset management firms with 25%. Banks would shed a mere 10%.
Kiuchi points to a possible liquidity risk, should these nonbank institutions suffer damage. If their clients try to cash their investments, the nonbank institutions would likely have to sell a diverse range of their assets to comply. As a result, "devaluations in high-risk products could lead to similar situations for stocks, bonds and other financial assets. The probability of a financial crisis happening with nonbanks as the epicenter is not low," he says, noting that "junk bonds, leveraged loans and CLOs doubled in market size in the decade up until 2020." With the assets gaining even more traction this year, the risks may be even more substantial.
Kiuchi says the current state of affairs was brought on by the global financial crisis, and that central banks need to do things differently if they truly want to remedy the situation. "The excessive monetary easing after the crisis a decade ago has led to the current asset bubble. Now, it's the high-yielding risky assets that are ballooning. Moreover, after the last crisis, banks were more strictly regulated, so now nonbanks hold such assets. I wouldn't be surprised if central banks, wary of the situation, clamped down on nonbanks next. However, regulations do not fix the problem: it just turns into a cat-and-mouse game. If they regulate one sector, another would just pick up those assets as long as they promise high returns... so the risk just gets passed on to other entities. In order to fundamentally fix this issue, central banks need to address the root of the problem: their ultra-loose easing policies. The markets need to be turned back into an environment in which high-risk investments are not so appealing."
There's no denying that normalizing policies could pose challenges: the markets might have another taper tantrum. However, Kiuchi says central banks need to be more mindful of longer-term financial stability. "When central banks tighten policy and there's confusion in the markets, central banks are criticized, so they tend to pause in their tracks... but that's just postponing the problem. In order to fix distortions in the markets, they need to be conscious of the financial system over a longer span. That means normalizing policies."
A financial meltdown can happen in an instant, especially if the markets are unsuspecting, and there's no knowing the size of the shock or the ripple effects. The global economy appears to be getting back on track as it recovers from the pandemic. At the same time, the ballooning growth of some assets is prompting worry that it could be headed for disaster. Whether the distortions in the markets can be remedied before the worst is allowed to happen remains to be seen.