OPINION | The shocks from the US sub-prime market collapse in 2007 reverberated around the world. The impact on confidence and growth was pronounced, leading to progressively bolder stimulus, through so-called quantitative easing. The co-ordinated, non-conventional policy from global central banks has been both unprecedented and mammoth.
This pushed investors further out along the risk spectrum, seeking higher returns than risk-free rates. About eight years later, it is timely to ask: has this push been too far? Peak liquidity, in terms of global aggregate central bank balance sheet size, will not arrive until about mid-2018, at US$14 trillion, so there is time for any excesses to build further.
On the one hand, it is understandable that many investors would seek to expand their investment remit in the face of such low returns from ‘safe’ assets. For example, the yield on the BAML Global Broad Market Bond Index stood at just 1.5 per cent at the end of May 2017. For those more conservative investors, the yield from government bonds was even lower, with the BAML Global Government Bond Index yielding a paltry 0.9 per cent. Considering G4 economy core inflation has been unable to break through 1.5 per cent (Goldman Sachs has the latest reading at 1.4 per cent), in real terms, bond investors are barely keeping their heads above water.
On the other hand, recent investor behaviour has shown worrying signs of desperation. Or at least some of the new asset classes that more adventurous custodians favour echo the late-cycle behaviour seen prior to the global financial crisis. How some of these more esoteric investments fare in a cyclical downturn is yet to be seen. Further, the jury is out as to whether the enthusiasm for higher yielding sectors has been matched by the skill of those new investors tackling them.
The move by non-bank institutions into private lending is one example. The waves of banking regulation that followed the GFC were well intended. The desire by policymakers to avoid a repeat of government bail-outs for large banks, and the consequent demands on taxpayers, led to sweeping changes to requirements for bank capital levels and lending practices. From Basel II, to III and now with Basel IV looming, banks have been nudged along by global regulation for the last eight or nine years.
The banks have become more utility-like, with lower returns on equity and tighter controls on behaviour. In Europe, for example, the average bank return on equity stood at less than 6 per cent at June 2016. In response, banks have re-purposed their loan books, pulling out of some areas where returns were not commensurate with risk or the required capital. In their wake, non-bank lenders have stepped in. The appeal is higher yields or spreads, due to more onerous credit work and weaker (or no) liquidity.
In the European market, for example, non-bank institutions are taking down more than 70 per cent of the leveraged loan market issuance during the 12 months ending in March 2017. In the early 2000s, this number was less than 30 per cent, as European banks took the lion’s share. The US market has also seen a rise in asset managers lending directly to corporations, with an estimated US$200 billion-$400 billion outstanding (per Institutional Investor).
An outsized impact
In addition to well-known names – such as KKR, Oaktree and Neuberger Berman – specialist players such as Ares Capital are growing quickly. In 2008, there were 16 US funds focusing on direct corporate lending; whereas, in 2016, this number had reached 55.
For now, this shift is modest in the context of a colossal global market for corporate bank lending (the US market alone is about US$9 trillion). However, despite the modest size, the macro-impact of this recent shift could be quite pronounced. This stems from the greater risks coming from private lending, which is not as closely audited, not as well capital-provisioned and in some cases not as experienced as equivalent bank lending.
Higher incidences of delinquent and defaulting loans could lead to a sudden end to this source of corporate finance, as recent institutional investors might retreat en masse. There are no real signs of this yet, with annual default rates running at low levels in Europe (circa 1 per cent). And despite rising sharply as the oil sector cratered in 2015-16, US default rates are modest at 2.7 per cent, having peaked at 13 to 14 per cent in 2001, 2002 and 2009. However, should the global economy weaken and corporations come under pressure, there could be more weakening in asset quality that would severely test the nascent private credit market.
Nick Bishop is head of Australian fixed income at Aberdeen Asset Management. He will participate in a panel titled “The effect of regulations on fixed-income markets” at the Investment Magazine Fixed Income, Cash and Currency Forum in Healesville, Victoria, on July 25-26, 2017. For registration enquiries, contact Emma Brodie: +61 2 9927 5708 [email protected] or visit the event website.