Equity markets have been calm and treading water in the last month after a good start to 2019. A less aggressive Federal Reserve and pause in US money tightening and has clearly been well received by investors. That said Standard & Poors, a leading ratings agency warned about global debt. In a recent report S&P, Next Debt Crisis: Will Liquidity Hold? they stated that global debt has risen by 50% since the global financial crisis in 2008, led by major economy governments and non-financial corporates in China. They warned another credit downturn may be inevitable although they considered contagion risk to be low.
The article in Investment Week that I read about the report stated that in absolute terms the US is the most indebted of all governments with an increase of $10.6 trillion of borrowing in the last 10 years. Debt in China and the Eurozone has also risen significantly. Interestingly household debt has decreased in the US and the Eurozone but it has surged in China.
S&P also noted the quality of the debt issued has deteriorated with large issuance of bonds with BBB credit ratings. As you are probably aware ratings agencies like S&P, Moody’s and Fitch rate the creditworthiness of bonds issued by governments and corporates. Although rating nomenclatures vary depending on the agency the most common is:
Investment grade – AAA, AA, A, BBB. BBB bonds are investment grade but are the lowest ranked of this quality.
Non-investment grade – BB, B, CCC, CC, C & D or variations thereof. In the US non-investment grade are often called junk bonds, just the sort of term to give investors a whole heap of confidence! Here in the UK high yield is the preferred description reflecting the fact that non-investment grade bonds must pay a higher coupon or interest rate to compensate investors for the additional credit risk they are taking. It is funny how the differing terminology colours the perception of whether non-investment grade debt is good or bad. Interestingly high yield debt is sought by income investors and it is less interest rate sensitive than investment grade bonds.
The higher the credit rating the more likely the issuer is to meet its obligations i.e. to pay interest and return investors’ capital at maturity. Bonds issued by the many Western governments and the strongest corporations tend to have AAA or AA ratings. According to S&P 61% of companies have aggressive or highly leveraged financial risk profiles. They also highlighted the greater use of non-traditional fixed income products and covenant-lite bonds with decreased protection for investors. These and BBB bonds are less liquid and more volatile than higher quality credits.
In a low interest rate environment default risk has been muted, but with rising rates and a slowing global economy defaults could pick up. Defaults range from the relatively minor, a delayed interest payment on a bond to the very serious not repaying bondholders their capital at maturity. However interest rate rises are a tool central banks use to curb inflation and inflation erodes the value of debt. Firstly inflation results in higher pay and prices and increases taxes which enables governments to pay down debt. In addition debts falls relative to assets. For example if you have a mortgage of £70,000 on a property of £200,000 and house price inflation results in a 30% increase to £260,000 over five years the ratio of debt to assets falls even if you have not paid off any of the mortgage. For corporates rising inflation may erode earnings. They may be able to increase the prices of their goods and services but labour costs rise as well.
So what do I conclude? Too much debt has a history of causing major economic problems. It happened during the Wall Street crash when people borrowed to invest in the stock market, subsequently wiping out a whole swath of the US banking sector. It happened in 2007-2009 when the US housing market and complex financial instruments built on debt collapsed, again bringing down the banks. It happened with Eurozone with the Greek debt crises and it is bound to happen again. That said undoubtedly the banks are much stronger financially now than they were during the global financial crisis, a decade ago. There are real risks but I don’t see too many red signals at this stage. Investing in equities for the long term should still deliver good returns whilst portfolios should be diversified and have a defensive core.
The content of this blog are my own thoughts and assessments based on the S&P report. Nothing in this article should be construed as personal investment advice, for example to invest in high yield bonds or equities. You should seek individual advice based on your own financial circumstances before making investment decisions.