The hunt for yield takes a risky turn

The types of high-risk debt securities that triggered the GFC are on the rise again, and the global fallout could be catastrophic.

At the epicentre of the 2008 financial crisis was the role of complex securitised debt products, most notoriously the securitisation of the riskiest tranches of collateralised debt obligations which were dubbed CDO squared products. Apparently, and disturbingly, they’re making a comeback.

The latest securities markets risk outlook issued by the International Organization of Securities Commissions overnight paints a disconcerting picture of the consequences of the global hunt for yield in a low interest rate environment.

With investors’ appetite for yield insatiable, and their concerns about risk having receded, there has been a return of riskier products to global markets.

The IOSCO report says that this year high-yield bond issuances will reach an historic high of $US617 billion; subordinated bond issues will be close to pre-crisis levels at about $US297bn; covenant-lite issues will be about $US177bn, and issues of ‘payment-in-kind’ debt (‘repaying’ debt by issuing more debt) and contingent capital also have increased to levels well ahead of those experienced pre-crisis.

Leveraged lending also has returned to pre-crisis highs, with about $US1.8 trillion originated this year. Margin debt in the US hit a record $US1.4 trillion in the first quarter of 2014. Leveraged financing via junk bond markets is also at pre-crisis levels of about $US119bn this year.

The asset-backed securitised products markets are seeing issuance levels only a fraction of those of the pre-crisis period but they are rising and, while CDO issues are, at about $US86bn, only about half their pre-crisis levels, they are now being issued at a rate of about eight times their post-crisis lows.

Issues of CDO squared products -- the packaging of the mezzanine or riskier tranches of asset-backed securities into securitised products -- peaked in 2007 at about $US53bn and disappeared in the aftermath of the crisis. This year IOSCO expects about $US86bn of CDO squared products to have been issued.

The growth in issues of riskier products is a reflection of growing risk and leverage in the system at a time when risk premia have fallen to negligible levels, which is historically not a good development.

The unintended consequences of the unconventional monetary policies being pursued by the advanced economies, reflected in ultra-low interest rates, can be seen in inflated asset markets and rising leverage.

US equities markets, for instance, are almost two standard deviations above their historical average according to IOSCO. Valuations in Europe are below their historical levels, but are rising. The spreads of investment grade and high-yield corporate bonds relative to US Treasuries are at very low levels.

US monetary policy is on the verge of a transition from the quantitative easing programs post-crisis that have expanded the Fed’s balance sheet by about $US3.6 trillion to more conventional settings, including the prospect of rates rising sometime next year.

With the eurozone still struggling to generate any growth -- IOSCO points to the risk of deflation in Europe -- there is a likely divergence of monetary policies looming.

That, as IOSCO says, could cause (and arguably is already causing) significant “adjustments” in exchange rates and impact financial markets more broadly.

Post-crisis there have been massive capital flows into emerging markets, pushing up asset prices and pushing down yields. That could reverse, making those markets, with relatively shallow levels of liquidity, a source of potential risk.

IOSCO appears particularly concerned about China’s wealth management products -- packaged loans backed by property developments, infrastructure projects and local government funding vehicles.

It says there is about $US2 trillion outstanding within those products, with many of them lacking quality and transparency. It says China’s shadow banking sector and its inter-relationship with the official banking system makes it a potential source of systemic financial risk.

Given the levels of public debt within the global financial system, levels exacerbated by governments’ responses to the crisis -- the gross debt-to-GDP ratios in advanced economies averages more than 100 per cent -- the ability of governments to respond to any new crisis would be more limited than in 2008.

The sharp appreciation of the US dollar in recent weeks appears to reflect a pre-emptive rush by investors to repatriate capital to the US before US monetary policy actually turns, unwinding some of the riskier carry trades that have developed in the pursuit of yield.

Whether that shift in capital flows increases the levels of risk in the system or helps to reduce them will only be clearer with hindsight. The IOSCO report, however, is a reminder that despite the relatively low levels of volatility and therefore of perceived risk, the world’s financial system remains a risky place.