What Will Cause the Next Debt Crisis?

For her CBC Massey Lectures in 2008, Canadian writer Margaret Atwood chose to talk about debt.

The text, written in the first half of the year, described how she’d noticed a lot more ads on public transportation for debt relief services. “Why are there so many of these ads? Is it because there are unprecedented numbers of people in debt? Very possibly,” she said.

Today, more than 10 years after the global debt-driven financial crisis that Atwood intuited, angst remains. Central banks that bought bonds and kept interest rates low to spur economic recovery have fueled record levels of corporate and government borrowing.

While Atwood’s lectures considered debt from historical, theological, literary, and even ecological perspectives, we asked investors and analysts to consider a simpler question as this credit cycle ages: What could go wrong now?

Kathleen Gaffney

VP & Director of Diversified Fixed Income, Eaton Vance Management

It’s got to be rates that cause a problem at some point. Then it’s a question of who goes first. Is it high yield? Is it loans? Is it investment grade? Because IG started to really crack more than high yield before December, because there just wasn’t enough of a cushion in credit spreads.

It seems like it’s all wrapped up in credit markets. Then it seems like it would be liquidity. It’s hard to tell exactly where it’s going to come from. I don’t think there’s a particular sector that’s so levered up that it’s something like that. It could be everything all at once.

Valuations are so tight, there’s too much risk there. I don’t see it as a seizure as much as a dramatic lesson in price discovery.

The idea that fixed income is no longer a safe hedge against equity volatility could create flows out of fixed income. There is this perception of safety. If you don’t have any return, then what’s the case for owning it?

Kristin Forbes

Professor, MIT’s Sloan School of Management, & Former Bank of England Policymaker

Risks are shifting to other sectors of the economy. We sometimes call it the “shadow financial system.” These risks now are in parts of the financial system that are less regulated, less monitored, and we have a less good idea of what those risks are and how they’re evolving. It could be the leveraged loan market, for example. Those are the sectors of the economy that I’m most worried about right now.

Michael Temple

Director of Corporate Credit Research for the U.S., Amundi Pioneer Asset Management

I actually don’t think it’s necessarily going to be the U.S. that’s in the epicenter. I think it’s going to be overseas. Clearly growth is a lot slower in Europe right now, and you’re seeing a number of countries in recession. Could you see defaults and increasing problems in Europe that ultimately cycle back to the U.S.?

And what about China ? If China cannot reinvigorate growth with its current stimulus program, then we could start to see problems coming out of China.

Greg Hahn

President & CIO, Winthrop Capital Management

We think we’re on the front end of a potential shift in the credit cycle. It’s going to show differently this time. We think it’s going to be expressed in the public markets through leveraged loans. One of the telltale signs is structured securities. Issuance is up, CLOs [collateralized loan obligations] are up. We’re seeing covenant-lite loans that are coming to market. These are all signs; 2017-, 2018-, and 2019-vintage structured securities could be problematic.

Adam Richmond

Head of U.S. Credit Strategy, Morgan Stanley

Partly because of the last financial crisis, the system is safer. The chance of another systemic crisis is very low. What we’re looking at is something more like 2002 in terms of the leverage built up.

Michael Buchanan

Deputy Chief Investment Officer, Western Asset Management

I always say you follow the money because that is where you really start to see excess risk build. Where is the money going now? Private credit.

There’s quite a bit of money that’s flowing in that direction, whether through institutional managers or BDCs [business development companies]. Investors didn’t necessarily need the liquidity that you get in the syndicated bond or syndicated loan market. If in exchange for that illiquidity risk, you could get better return on capital through higher yield, that made a lot of sense.

There has been a tremendous amount of demand for private credit. But investors knowingly went into private credit understanding that there was real illiquidity there. The mark-to-market could be pretty painful when things do turn, but in terms of how they have these assets allocated, they fall within an illiquid bucket. That’s one factor that could prevent it from becoming a systemic crisis.

Peter Tchir

Head of Macro Strategy, Academy Securities Inc.

I don’t think there’s going to be another credit crisis because I don’t see the leverage in the trading system. In the financial crisis, everything was kind of interconnected. As soon as one part of the capital structure started getting in trouble, everything had to get sold. There was a lot of mark-to-market risk.

I do think we can get bouts like we saw in December, where the ETFs in particular drive prices lower, but they can rebound quickly. There’s just not liquidity. But I don’t see people being forced out of the market.

Priya Misra

Global Head of Rates Strategy, TD Securities

If you do have people worried about the deficit plus a downturn, you could see an increase in real rates. You’re seeing this in Canada. Because their mortgage market is much more floating-rate, you’re seeing the impact on the consumer.

A lot of people attribute the risk-off in the fourth quarter to the Fed’s shrinking balance sheet. I attribute it to the increase in real rates. When real rates rise, people move out of credit into Treasuries. If we get inflation, we can handle higher rates. If we don’t, that’s more damaging.

Jim Bianco

President & Founder, Bianco Research LLC

What would cause creditworthiness to get devalued would be a recession or economic slowdown. We’re seeing that to some extent in Europe.

The next question is what would cause rates to go higher. And that would be inflation. We don’t really understand inflation. Whenever you’re in year 10 of a recovery and a bull market, obviously there are excesses, and I don’t think we all know where they are.

Kristina Hooper

Chief Global Market Strategist, Invesco Ltd.

The one significant catalyst would be quickly rising rates, and I don’t see that happening anytime soon. If anything, what we’ve seen is central bank after central bank accept the fact that they need to get more dovish, even though they’re very interested in normalizing to prepare for the next crisis.

We all worry about the triple-B [credit rating] space, just because there’s been such an increase in that space and because it hangs on the precipice of being knocked over. And of course there’s a lot in the way of refinancings to expect. Not this year but really next year, 2020, we should see about 10 percent of those bonds needing to be refinanced. That is probably the first area that we’d want to look to.

I also worry about specific places like auto loans, where we’ve just seen defaults go up quite significantly. Is it going to cause the kind of crisis that we saw during the GFC [global financial crisis]? No. But that suggests weakness in pockets, and we want to follow that closely.

 

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