According to RiskMinds International attendees, one of the things that will keep CROs up at night in 2019 is the threat of another financial crisis. Patrick Tan, General Partner at Compton Hughes, predicts that this time corporate debt will be the culprit. But how will investors "seek to mitigate against the vagaries of the onslaught of questionable corporate debt"? Tan makes an educated guess and points to cryptocurrencies.
While the last financial crisis was lead by mortgage debt, the next financial crisis will likely be lead by corporate debt and it is unclear if central banks will have sufficient tools in their toolkit to solve the next crisis.
During the last financial crisis, one of the immediate consequences of Lehman Brothers’ bankruptcy was that the market for corporate paper (or credit) that was actively traded between banks dried up.
Overnight, companies found themselves unable to make payroll, pay suppliers, pay for transport services — all the key processes needed to keep businesses rolling, had ground to a halt.
But companies soon learned from the lessons of the financial crisis.
As central banks slashed interest rates to near zero or negative interest rates at times, companies found that commercial banks were no longer reliable counterparties for corporate paper.
And given that investors took advantage of massive amounts of liquidity flooding the market, the search for yield gained steam.
Nowhere was this more prevalent than in the corporate bond market, with companies offering every measure of high coupon rate debt instrument and in some cases so-called “perpetual bonds” which had no maturity dates. Think of it as an I-O-U forever.
If investors had done their research, they would know that some of the ten largest companies in the United States today, did not even exist fifty years ago. (“But what about muh perpetual bond?”)
Which made the “value” of these perpetual bonds dubious at best. Yet investors, hungry for yield lapped them up — a bit like kicking the bucket down the road, because another investor would ideally pick these perpetuals or “perps” (not to be mistaken with perpetrators although the distinction may be more a matter of semantics) up. The result has a been a troubling legacy of corporate debt and share buy-backs as well as a record cycle of mergers and acquisitions.
With the specter of a looming U.S.-China trade war, an uncertain Brexit situation in Europe and slowing growth in China, as well as rising geo-political tensions, from the Middle East to Taiwan, there are myriad reasons to be concerned.
Even more troubling however has been the quality of the debt raised. Yield-starved investors seeking fixed returns above the meager levels provided by cash and government bonds were only too happy to lap up any and all manner of corporate debt, with Triple B grade debt (the lowest quality tier of investment grade debt) having grown from US$750 billion at the end of 2007 to an eye-watering US$2.7 trillion in the U.S. alone.
And there are significant headwinds now facing that corporate debt. With the specter of a looming U.S.-China trade war, an uncertain Brexit situation in Europe and slowing growth in China, as well as rising geo-political tensions, from the Middle East to Taiwan, there are myriad reasons to be concerned.
A hawkish Fed has also increased expectations of rising interest rates and weaker earnings reports over the coming year (Apple may have been only the first crack in the dam), a large chunk of Triple B-rated corporate paper is at risk of heading into the high yield or junk market. The Triple B market has already shed 3% since last year, its worst annual run since the financial crisis and according to some analysts, this is only the beginning.
According to the Institute of International Finance (IIF), Triple B corporate debt accounts for 42% of all U.S. corporate debt, up 30% from 2009. The trend also reflects how investors have progressively gone downwards on the ratings ladder in search of yield, increasing their risk exposure for a few more basis points of yield in some cases, dramatically skewing normal risk-reward ratios and throwing actuarial models out the window. According to the IIF, “this suggests that a rapid tightening in financial conditions or a growth shock would severely stress weaker issuers”.
The lowest investment grade corporate paper is (at least internally) being viewed by some of the largest buyers and sellers of that same corporate paper as increasingly junk grade.
Over at the J.P. Morgan brain trust, the flows and liquidity team has noted that the median net debt to EBITDA (Earnings Before Interest Taxes Depreciation Amortisation) for U.S. and European high grade and high yield corporate debt has risen steadily since the financial crisis and “this leverage metric” stands “much higher than at the peaks of the previous two cycles.”
“From a net debt to EBITDA ratio point of view, more than half of Triple B companies in the U.S. and Europe look more like high yield than high grade.”
In other words, the lowest investment grade corporate paper is (at least internally) being viewed by some of the largest buyers and sellers of that same corporate paper as increasingly junk grade.
And concerns that corporate debt may soon run out of favour is exacerbated by the Fed’s shrinking balance sheet. In an effort to balance the books, the Fed is issuing more bonds, buoyed in large part by the anticipated US$1 trillion budget deficit this financial year and which may fuel a rotation between corporate and government debt.
With the prospect of increasing geo-political uncertainty and rising interest rates, there are ample reasons for U.S. government debt to come back in play once again. Even one of the largest managers of private credit funds, KKR has warned that credit, albeit corporate credit, is likely to be the big story for 2019, warning against lending to highly indebted companies.
Now, had companies borrowed to fund growth or research and development, that would be one thing. Instead, companies have seen it fit to use the debt markets as their own personal ATMs to fund non-productive share buy-backs that do little other than to increase the value of the stock of senior executives, whose remuneration is often tied to stock price.
Are there indicators that cryptocurrencies will once again rise to the forefront as investors seek to mitigate against the vagaries of the onslaught of questionable corporate debt? Certainly.
During the last financial crisis, the seizure of the credit markets, while an unexpected consequence of allowing Lehman Brothers to fail, also allowed central banks to very quickly identify the logjams, soaking up the toxic assets and breathing life back into the credit markets in relatively (and I use this word loosely) short order.
Because the major players in the last financial crisis were relatively large nodes of the global financial system, shoring them up (while politically controversial) was at the very least sufficient to allow global financial markets to make the steps necessary to achieve normalcy.
But with Triple B grade corporate paper, the silver bullets may not be so easy to fire because in a decentralised corporate credit collapse, which companies are essential for rescue and which ones are not?
How could central banks then justify saving some legions of Triple B while allowing others to fail without the allegations of arbitrariness and favoritism being leveled against central bankers?
Up till the failure of Lehman Brothers, as far as possible, then U.S. Treasury Secretary Henry Paulson was cautious to steer away from the moral hazard of a government-backed bailout of private companies, but with that moral hazard since breached, would the public now be willing to allow central bankers to use public money to once again fund scores of reckless and self-serving companies?
Against the backdrop of the last financial crisis and frustrated with the (mis)use of taxpayer money to bailout private corporations, the Bitcoin whitepaper was born.
And with the ever-growing possibility that the next credit-fueled financial crisis will come from corporate debt looming over the horizon, are there indicators that cryptocurrencies will once again rise to the forefront as investors seek to mitigate against the vagaries of the onslaught of questionable corporate debt? Certainly.
In the last financial crisis, no one had even heard of, let alone understood Bitcoin. In fact, it took almost a decade before Bitcoin and other cryptocurrencies came to the fore and grabbed global headlines and consciousness.
Corporate debt is worrying, but what is more worrying is the repeated credit-fueled boom-bust cycles that almost always favour the elite with the brunt of the costs being borne by ordinary citizens.
By any measure, given the relative size of cryptocurrencies against the global financial markets, you would think they were Drake or the Kardashians. Cryptocurrency markets are tiny, US$120 billion on a good day — and these aren’t even accurate numbers. Yet a simple media monitoring program will reveal their outsize coverage on some of the most respected and revered publications in the world, from Financial Times to Bloomberg, Forbes to Fortune and the Wall Street Journal and New York Times, cryptocurrencies get a lot more media and publicity than they arguably deserve.
If and when the next credit-fueled financial crisis hits, the world is already aware of cryptocurrencies.
And the same economic, political and social conditions which allowed for the rise of cryptocurrencies have not vacated, but are very much present in the world today, if not more so.
So it is entirely possible for the next financial crisis to result in a surge of interest and demand in cryptocurrencies, for the very same reasons that gold acts as a safe haven in times of economic, social and political turmoil.
The recent Brexit chaos has already resulted in the highest levels of account registrations in the United Kingdom for Binance trading accounts and volumes and interest in cryptocurrencies have surged across the British Isles.
The same way water always finds its level, people and commerce will find a way. And increasingly, that way seems to be tilting in favor of cryptocurrencies.
As people become increasingly aware that governments (the U.S. included) can no longer be depended on to not only do the right thing, but to husband the economy for the benefit of citizens, it is entirely possible for the rise of the decentralised, grassroots-led value system of cryptocurrencies.
Corporate debt is worrying, but what is more worrying is the repeated credit-fueled boom-bust cycles that almost always favour the elite with the brunt of the costs being borne by ordinary citizens.
That the British are already contemplating alternatives such as Bitcoin, in what is considered a stable, Western democracy should be telling.
Pundits have long criticised Bitcoin and its ilk as being unneeded in stable Western democracies, relegating its use to failed economic states such as Venezuela and Zimbabwe. Depending on how Brexit ultimately plays out, the surge of interest in cryptocurrencies in the United Kingdom against the backdrop of Brexit chaos should provide some evidence that such assumptions may not necessarily be unassailable.
The same way water always finds its level, people and commerce will find a way. And increasingly, that way seems to be tilting in favor of cryptocurrencies.
Discuss cryptocurrencies and cryptotrading at Finovation Summit, part of RiskMinds Americas.
