Italy’s National Bankruptcy Is Imminent

The new Italian government will increase public spending and public debt.

It promised to reduce taxes, introduce basic security and reform pensions. Italy's Northern League's leader Mateo Salvini surged in the polls and the party is now the strongest in Italy.

A couple of years ago it was inconceivable that this regional group could become Italy's leading political party. We should expect more to come. As the saying goes, it just could not happen till it happened.

The financial establishments in North European countries like Germany and the Netherlands assume that the politicians of M5S and Lega Nord will follow the Greek script and will backtrack on their promises.

But Mateo Salvini and Prime Minister Giuseppe Conte know that if they do not live up to the expectation of the voters, they will be voted out of office.

They are also aware of it that the Italian voter has still another alternative called "CasaPound", a much more radical, if for the time being insignificant, social and anti-migration movement.

The planned reforms could burden the state budget with an additional 125 billion euros per year. Can the Italian government afford such a thing?

The question is rhetorical when you look at Italy's growing debt mountain.

It amounts to €2300 billion, of which 1900 billion are government bonds.

What should worry investors, however, is the structure of this debt. Ten years ago, when the last financial crisis broke out, 51% of these government bonds were hold by foreign investors. When the climate for investment in a country deteriorates, they sell these bonds immediately. When in 2011 the Berlusconi government threatened to withdraw from the eurozone budget rules because of the huge budget deficit, German and French banks sold Italian government bonds BTP (Buoni del Tesoro Poliennali) worth a total of €150 billion. In the following years, foreigners bought Italian debt instruments again for around €100 billion, but their share is now very low at 36%.

Most of the packages currently are owned by Italian banks and insurance companies, and their financial condition is already weak: last year the Italian government rescued, Banca Monte dei Paschi di Siena at the expense of the Italian tax payer, against the wish of the Frankfurt banking establishment. The Italian financial situation became more sensitive when there was turbulence around the new Italian government in May this year: the Italian BTPs (Buoni del Tesoro Poliennali Italian Government Bonds) lost 8% in value. If prices remain under pressure, Italian banks will have to sell off these bonds at a lower price and with huge losses to ensure that their solvency will not be further endangered. To comply with the European debt-to-capital ratios, they have to raise new capital or increase interest rates and grant fewer loans.

Also the ECB is responsible for the rising yield on Italian government bonds. When in May the Five-Star Movement and the Lega merged to form a government coalition, the ECB suddenly reduced purchases of Italy's national debt, which exacerbated speculation against the BTPs. In this way Brussels wanted to punish the Eurosceptic "populists". This was confirmed by Günther Oettinger himself, who always considered Italy ungovernable. In an interview for Deutsche Welle, he called the turmoil on the financial market "a signal to Italian voters not to vote for populists from left and right". In plain language – if they had elected corrupt democrats who were not breaking ranks with Brussels, the Italian debt could have continued to be financed by the ECB.

The introduction of a parallel (or fiscal as the Italian like to call it) currency is one of the promises that the new Italian government has given to make "Italy Great Again". The central bankers from Northern Europe we talked to are appalled by the idea and are convinced that Italians will not even consider such a plan. Its author – Paolo Savona – the current Minister for Europe – already claimed in 2015 that the denomination of euro national debt into new fiscal currency "nova-lira" national debt was neutral for domestic investors.

This claim is not true, however, because since January 2013 all government bonds in the euro zone have been issued with a so-called collective action clause. CAC means that the issuing state may not change the bond terms on its own: any change requires the consent of the majority of creditors. The share of BTPs with CAC compared to that without CAC has been rising continuously for years. In 2017 it was 48%, this year it will already reach 60%, so that Savona's plan is hardly feasible.

Italy's national bankruptcy is imminent and the next financial crisis can soon be triggered off by problems of the Italian banks, which the ECB and Brussels' technocrats are unwilling to rescue, all the more so since Lega and Movimiento 5 Stelle are in power.

The Coming High Yield Downturn will be Big, Long and Ugly

          The US high yield market has grown larger and riskier since the financial crisis. Issuers of debt have the 

whip hand as buyers compete to gain an allocation in the face of surging demand from CLOs and retail funds.

Companies are emboldened to seek ever weaker covenants and are taking advantage of the current conditions

to borrow more at lower margins. It's as if the financial crisis never happened and the lessons from it are ancient 

history. Whilst the timing of a downturn in high yield debt isn't predictable, the outcomes when it does happen are. 

More debt, of lower quality, with weaker covenants means the coming downturn will be bigger, longer and uglier.

A quick review of some key data makes this clear. 

          Firstly, the size of the US high yield bond market and leveraged loan market are both close to double what 

they were in 2007.
          Not only is the debt outstanding larger, but the credit ratings have shifted downwards on leveraged loans.

Lower credit ratings mean a higher percentage of the outstanding debt will default when liquidity dries up.
          The other key indicator to watch is the share of the loan market that has weak covenants. In 2007, 17%

of outstanding loans were covenant-lite. Today it's over 75% with over 80% of new issuance lacking decent

covenant protections. Weak covenants delay the occurrence of an event of default, which allows zombie 

companies to continue operating until they either exhaust their cash reserves or cannot refinance maturing debt.

High yield bulls are likely to cite the substantial equity contributions from sponsors and healthy interest coverage

ratios as reasons not to be overly concerned. These are definitely much better than 2007, but these indicators do

have some inbuilt weaknesses. Equity contributions are only as good as the market valuations they are based on.

As US equities are arguably overpriced, sponsors are having to pay more than they historically would have to 

purchase a company. If price/earnings ratios revert to lower levels, company valuations will fall wiping out some of

the equity cushion and making the debt a higher proportion of the enterprise value.
            Interest coverage ratios are also benefitting from two deviances from historical levels. Libor has been low

but is now on an upward path. For companies that have hedged, either via interest rate swaps or by issuing fixed

rate debt, their protection will last for a time. For those with floating rate debt and no interest rate swaps their interest

coverage ratios will generally have started to fall already due to higher Libor.
The average margin paid on top of Libor for leveraged loans is now at close to the lowest levels since 2007. 

When adjusted for the risk being taken, spreads are at the lowest levels since 2007. When spreads revert, issuers with

near term maturities will be the first to feel the impact with higher interest bills pushing their interest coverage ratios down.

What Might the Next Downturn Look Like?

We can use the size of the high yield debt market and the probabilities implied by the current credit ratings to estimate

how much debt might default. Using the historical average three year default rates we would expect over $250 billion of

debt to default in the next three years. However, high yield debt default rates rarely sit at the average level with long 

periods below the average and short bursts way above the average. Looking back to the downturns immediately following

the tech wreck and the financial crisis, those three year periods posted roughly double the average default levels. 

This points to the next downturn seeing over $500 billion of high yield debt defaulting.  There will be plenty of opportunities

for the $74 billion of dry powder held by distressed debt funds.

However, the substantial increase in covenant-lite loans will flatten and lengthen the default cycle. Zombie companies will

struggle on for longer as the lack of maintenance covenants stops lenders from forcing equity raisings, assets sales or

bankruptcies that would better protect their positions. Whilst this will delay inevitable restructurings, investors will see 

their returns impacted far earlier as markets will reprice the debt of zombie companies to distressed levels well before

the losses crystallise after a default.

The impact of covenant-lite levels on recoveries is disputed, with some historical data pointing to better outcomes

achieved on covenant-lite loans. Managers often point to this data to argue that their investors have little to worry

about from the growth of covenant-lite. These arguments can easily be seen as self-serving, as managers have to

defend their investments in order to continue to earn their management fees. Few managers are willing to hand back

capital or to substantially change strategy when conditions in their market segment are unfavourable.

Moody's takes a very different view and is forecasting an average recovery rate of 60% on first lien loans, well below

the historical average of 85%. They cite more covenant-lite lending and lower levels of subordinated debt as increasing

the risks for lenders. The covenant-lite loans being made today are very different from those made in 2007, which

were almost exclusively made to lower risk borrowers. Today covenant-lite loans are made to both lower and higher risk

borrowers with less cushion provided by second lien loans and unsecured high yield bonds.

How Should Investors Respond?

Given we know that value in US high yield debt is currently poor, there are three main options to respond; switch to

cash, de-risk or change sectors.

Switch to cash: The first reaction to poor value is typically to sell out and sit in cash. As the spread in high yield debt is

barely covering the average expected losses from defaults this isn't as extreme as it might seem. The increasing return

on cash like investments in the US has recently risen above the dividend yield on the S&P 500. Add in the expectation

of additional increases in the Federal Funds Rate and going to cash is a legitimate alternative whilst waiting for a correction

in high yield debt. The lost carry of 3-4% per annum is the main downside and investors need to be prepared to pay this

price for an unknown period, potentially several years.

De-risk: Switching from B and CCC rated debt to BB rated debt, selling covenant-lite loans/bonds and targeting shorter

 duration debt are all ways to reduce the risk but still stay invested in high yield debt. Like switching to cash, this will reduce

 the carry on the portfolio but the give-up is only 1-2% per annum if an investor is starting with an average portfolio.

 Execution of the switch may be tricky though, as there will be a very limited universe left after applying two or more of these

 de-risking filters. What remains will mostly be older vintage debt, which is often very tightly held.

Change sectors: Another common strategy is to give up some liquidity by shifting from public loans and bonds to private debt.

 The higher historical returns and stronger covenant packages would make this a very obvious shift if not for the huge amounts

 of capital that have flowed into private debt in recent years, competing away some of the returns. This may turn out to be a

 case of past returns not being a reliable indicator of future results.

For my clients, I've been implementing a switch to property debt. The pullback of the major Australian banks from investor

 lending, interest only loans and foreign buyers has open up a substantial gap for others. Senior loans secured by completed

 residential property, borrowers with substantial excess income, with low duration (2-5 years) and low LVR/LTV ratios (60-70%)

 are delivering net returns of around 6.50%. The illiquidity of these loans is substantially lessened by their low duration, 

which will see principal returned over the medium term when other credit investments are hopefully offering a better risk/return

 proposition. There is capacity for at least one institutional investor to put significant capital to work in this strategy.

Conclusion

US high yield debt has grown larger and riskier since the financial crisis. The combination of lower ratings and covenant-lite

 lending points to the next downturn being longer and having lower recoveries with over $500 billion of defaults likely. Investors

 are currently receiving minimal spread over historical average loss levels making the status quo an unattractive position.

 Switching to cash, de-risking portfolios or changing sectors are all legitimate ways to reposition portfolios with a view to

 reinvesting at lower prices in the medium term.

A Japanese Tsunami Out Of US CLOs Is Coming

Japan is at the very centre of the global financial system. It has run current account surpluses for decades, building the world's largest net foreign investment surplus, or its accumulated national savings. Meanwhile, other nations, such as the US, have borrowed from nations like Japan to live beyond their own means, building net foreign investment deficits. We now have unprecedented levels of cross-national financing.

Much of Japan's private sector saving is placed in Yen with financial institutions who then invest overseas. These institutions currency hedged most of their foreign assets to reduce risk weighted asset charges and currency write down risks. The cost of hedging USD assets has however risen due to a flattening USD yield curve and dislocations in FX forwards. As shown below, their effective yield on a 10 year US Treasury (UST) hedged with a 3 month USDJPY FX forward has fallen to 0.17%. As this is below the roughly 1% yield many financial institutions require to generate profits they have been selling USTs, even as unhedged 10 year UST yields rise. The effective yield will fall dramatically for here if 3 month USD Libor rises in line with the Fed's "Dot Plot" forecast for short term rates, assuming other variables like 10 year UST yields remain constant.

As Japanese financial institutions sell US Treasuries, which are considered the safest foreign asset, they are shifting more into higher yielding and higher risk assets; foreign bonds excluding US treasuries as well as foreign equity and investment funds. This is a similar pattern to what we saw prior to the last global financial crisis. In essence, Japan's financial institutions are forced to take on more risk in search of yield to cover rising hedge costs as the USD yield curve flattens late in the cycle.

Critically as the world's largest net creditor they facilitate significant added liquidity for higher risk overseas borrowers late into the cycle.

I follow these flows closely. One area I think is rather interesting is US Collateralised Loan Obligations (CLOs) which Bloomberg reports "ballooned to a record last quarter thanks in large part to unusually high demand from Japanese investors". CLOs are essentially a basket of leveraged loans provided to generally lower rated companies with very little covenant protection. Alarmingly, some US borrowers have used this debt to purchase back so much of their own stock that their balance sheets now have negative net equity. A recent Fed discussion paper shows in the following chart that CLOs were the largest mechanism for the transfer of corporate credit risk out of undercapitalised banks in the US and into the shadow banking sector. Japanese financial institutions have been the underwriter of much of that risk in their search for yield.

There are many other risky areas where Japan has become a large buyer, including; Australian Residential Mortgage Backed Securities, Emerging Market Bonds, and Aircraft Leases. Japan's financial institutions have desperately sought the higher yields on offer not only to compensate for higher hedge costs but also their dire domestic earnings outlook as the Bank Of Japan (BOJ) suppresses domestic interest rates below the break-even rates that many of these institutions need to remain profitable. A former BOJ Board member Takahide Kiuchi warns "there is no doubt that as a side effect of monetary easing, financial institutions are taking excessive risk". (Japanese) Banks are investing in products that yield too little relative to the risks involved. You tell banks to stop it, and then they go elsewhere to find opportunities — it's whack-a-mole". Importantly, Japan's Financial Services Agency is now instructing regional banks, to not only stop adding foreign higher risk assets but also to aggressively sell existing positions as soon as they begin to turn sour.

Unfortunately, this doesn't resolve the problem as restricting financial institutions like regional banks from buying higher yielding foreign assets removes their ability to offset their deteriorating domestic businesses. The situation will likely worsen, as even the BOJ Governor Kuroda himself acknowledges that continuously supressed interest rates will increasingly deteriorate domestic banking earnings over time as old higher yielding assets continue to roll-over onto lower rates. There is limited prospect of the BOJ meaningfully lifting interest rates to slow that deterioration. All of the BOJ's measure of underlying inflation have deteriorated this year. In addition, as the chart below shows, currency effects, which had brought some limited inflationary pressures to Japan earlier in the year, are now set to bring deflationary pressures.

An unstated objective of the BOJs monetary policy has been to weaken the Yen. As suppressed domestic interest rates also creating carry trade outflows from some Japanese investors who are willing to take unhedged currency risk. The 2016 commitment to keep interest rates pegged below zero out to 10 years, via yield curve control, has again pushed the Yen to near extreme levels of devaluation against its long-term average real effective exchange rate. The Yen is currently 23% undervalued against its export partners.

We can use purchasing power parity to specifically measure the undervaluation of the Yen versus the USD. The current 30% undervaluation implies a fair value of USDJPY 77. Surveys of Japanese exporters estimate  that they only break-even on average at above USDJPY 100.5. It is clear that the BOJ would be desperate not to trigger a reversal of carry flows and push the Yen back up to fair value by raising interest rates.

The BOJ has to make a choice and there are no good options.

If the BOJ raises interest rates they risk triggering a tsunami of Japanese money flowing back home, strengthening the Yen and amplifying the coming deflationary pressures. In addition, much of that money is currently propping up higher risk overseas debt markets like US CLOs. If Japan, the world's largest creditor, brings its money back home that would bode extremely poorly for the global credit cycle, which Japanese financial institutions are now more than ever directly exposed to.

If the BOJ doesn't raise interest rates, which I think is the likely outcome, then some Japanese financial institutions  will simply not be able to survive as privately owned listed entities in their current form as their domestic earnings will fall increasingly negative and they are restricted from seeking overseas earnings.

Regional banks are the entities which are suffering most and conditions have continued to deteriorate further since I wrote earlier in the year of policies in place already that would allow these entities to be resolved into more viable formats. Essentially, the cost of continuing current policy would be to zero the shareholders in some of these banks, a cost Japan has proved willing to bear on a number of occasions in recent decades already. I can see this as being the most politically palatable choice, out of a range of bad choices and see continued appealing returns in Japanese regional bank shorts

The 'Dirty Dozen' Sectors Of Global Debt

When considering where the global credit cycle is at, it's often easy to form a view based on a handful of recent articles, statistics and anecdotes. The most memorable of these tend to be either very positive or negative otherwise they wouldn't be published or would be quickly forgotten. A better way to assess where the global credit cycle is at is to look for pockets of dodgy debt. If these pockets are few, credit is early in the cycle with good returns likely to lie ahead. If these pockets are numerous, that's a clear indication that credit is late cycle.

This article is a run through of sectors where I'm seeing lax credit standards and increasing risk levels, where the proverbial frog is well on the way to being boiled alive.

Global High Yield Debt

Last month I detailed how the US high yield debt market is larger and riskier than it was before the financial crisis. The same problematic characteristics, increasing leverage ratios and a high proportion of covenant lite debt, also apply to European and Asian high yield debt. Even in Australia, where lenders typically hold the whip hand over borrowers, covenants are slipping in leveraged loans. The nascent Australian high yield bond market includes quite a few turnaround stories where starting interest coverage ratios are close to or below 1.00.

Defined Benefit Plans and Entitlement Claims

For many governments, deficits in defined benefit plans and entitlement claims exceed their explicit debt obligations. The chart below from the seminal Citi GPS report uses somewhat dated statistics, but makes it easy to see that the liabilities accrued for promises to citizens outweigh the explicit debt across almost all of Europe.

In the US, S&P 500 companies are close to $400 billion underfunded on their pension plans. This doesn't seem enormous compared to their annual earnings of just under $1 trillion, but the deficits aren't evenly spread with older companies such as GE, Lockheed Martin, Boeing and GM carrying disproportionate burdens.

Latest forecasts have US Medicare on track to be insolvent in 2026. At the State government level Illinois ($236 billon) and New Jersey ($232 billion) both have enormous liabilities, mostly pension and healthcare obligations. If you want to understand how pension and entitlement liabilities have grown so large, my 2017 article on the Dallas Police and Fire Pension fiasco and John Mauldin's recent article "the Pension Train has no Seatbelts" are both worth your time.

US State and Municipal Debt

Meredith's Whitney's big call of 2010 that US state and local government debt would suffer a wave of defaults is generally considered a terrible prediction. However, after the 2013 default of Detroit and the 2016 default of Puerto Rico history might ultimately record her as simply being way too early. Illinois is leading the race to be the first default over $100 billion in this sector, but New Jersey and Kentucky could make a late surge. When the next crisis strikes and drags down asset prices, these states will see their pension deficits further blowout. At that point, there's no guarantee they will continue to be able to rollover their existing debt.

The key lesson from Detroit's bankruptcy was that bondholders rank third behind the provision of services and pensioners in the order of priority. Recovery rates of less than 30% should be expected when defaults occur. The key lesson from Puerto Rico was that just because a state or territory isn't legally allowed to default, doesn't mean that the Federal Government won't intervene to allow creditors to suffer losses.

US Mortgage Debt

In the 2003-2007 housing boom, subprime residential lending was largely the domain of private lenders. Fast forward to today and the government guaranteed lenders are busy repeating many of the same mistakes. Borrowers with limited excess income and little or no savings are again getting loan applications approved. Fannie Mae and Freddie Mac remain undercapitalised with their ownership status unresolved, leaving the US government to pick up the tab again when the next wave of mortgage defaults arrives.

Developed Market Housing

It's not just the US with excessively risky housing debt, Canada, Australia, Hong Kong and the Scandinavian countries are all showing signs of some borrowers taking on too much debt. Canada deserves a special mention as it combines skyrocketing house prices with second lien, HELOCs and subprime debt. It's hard not to make comparisons with the US, Ireland and Spain pre-crisis when you see those factors present.

US Subprime Auto

The occasional articles claiming that US subprime auto debt is this cycle's version of subprime residential debt are substantially overstating the potential damage that could lie ahead. Cars cost an awful lot less than houses with auto securitisation volumes today running at around 7% of subprime home loan volumes in 2005 and 2006. This isn't an iceberg big enough to sink the Titanic but it is a warning of the presence of other icebergs.

The quality of subprime auto loans is poor and getting worse with minimal checks on the borrower's ability to afford the loan. Whilst unemployment has been falling, default rates have been increasing, a clear indication of how bad the underwriting has been. Lengthening loan terms and higher monthly payments are some of the ways lenders have been responding to the rate increases by the Federal Reserve. Some debt investors aren't too worried though, recent deals have sold tranches down to a "B" rating. In 2017, issuance of "BB" rated tranches were sporadic but as margins on securitisation tranches have fallen investors have pushed further down the capital structure.

US Student Loans

The chart below from the American Enterprise Institute breaks down US CPI into the various components. Textbooks and college tuition are the standout items with childcare and healthcare also notable. Soaring education costs have had to be paid by students, who ramped up their use of student loans. A handful of former students have managed to end up owing over $1 million. Total student debt owing is now $1.49 trillion up from $480 billion in 2006, more than credit card balances and auto loans.

Remember that many students never finish their degrees and others end up working in positions that don't require degrees. This helps explain why over a quarter of student loans are in some form of default, deferment or forbearance. Most loans are owed to the US government, leaving taxpayers to foot the bill for defaults. Private lenders tend to cherry pick the better borrowers, often waiting until borrowers have graduated and found work before offering to refinance and consolidate their loans at a lower interest rate.

Emerging Market Debt

Whilst the developed market debt to GDP ratio has increased modestly in the last decade, emerging market debt levels have rapidly increased. China certainly skews these ratios with its extraordinary debt binge, but many other emerging markets have followed a similar pathway. The graph below from the IIF shows the combined ratios, but there's a different make-up for developed and emerging markets. In developed markets the financial crisis led to soaring government debt to GDP ratios as governments ran deficits and bailed out banks and corporations. In emerging markets consumers, corporates, governments and banks have all increased their use of debt.

Debt markets are starting to wake-up to the risks with Argentina, Turkey, Mozambique and Bahrain all attracting the wrong sort of attention this year. This is a change from last year when I wrote about Argentina and Iraq selling bondseven though their prospects of repaying their debts appeared low. There's been a long period of loose lending in much of the Middle East, South America and Africa similar to the conditions before the Asian financial crisis and the Latin American debt crisis.

Developed Market Sovereigns

The European debt crisis kicked off in 2009 with frequent flare ups since then. Greece's default and restructure in 2012 saw private sector lenders take a haircut and contributed to Cyprus's bailout later that year. The rolling series of ECB and IMF negotiations with Greece show that it's structural problems are far from resolved and another default is likely in the long term.

Italy recently saw its cost of borrowing spike after the political parties that formed the new government considered asking the ECB for €250 billion of debt forgiveness. Both Greece and Italy have very high government debt to GDP ratios, consistently low or negative GDP growth and precarious banking sectors. Other developed nations most at risk are Japan and Portugal, ranked first and fifth respectively on their government debt to GDP ratios.

European Banks

The link between banks and sovereigns is critical to their solvency. Failing banks are often bailed out by governments, further increasing government debt levels. Failing governments often bring down their banks, as banks typically use government debt for liquidity purposes often treating it as a risk free asset. Europe has both problematic governments (Greece, Italy and Portugal) and problematic banks, mostly in Greece, Italy, Spain and Portugal. Deutsche Bank stands out for its size, high leverage and losses in each of the last three years. Given Deutsche Bank's market capitalisation is little more than 1% of its asset base and it has shown an inability to generate a decent profit, a bail-in of senior debt and subordinated capital is arguably the only way to rectify its perilous situation.

Chinese Corporate Debt

The rapid growth of debt in China since 2009 is dominated by the corporate sector. The chart below from Ian Mombru shows that China has the highest corporate debt to GDP ratio of any country. Close to half of the debt is owed by property companies and property linked industries. This is a major risk as Chinese property is overpriced relative to incomes and there's widespread overbuilding, especially in the ghost cities. As with almost all debt in China, there's several issues that make risk assessment far murkier than it should be.

First, many Chinese corporates have a material level of government involvement; by direct shareholding (state owned entities), shareholdings by high ranking communist party officials, direct and indirect government guarantees of debt, communist party representatives on committees or by having local or the national government as a major supplier or customer. The distinction between corporate debt and government debt, and whether government will support a corporate that gets into financial trouble is near impossible for outsiders to accurately assess.

Second, Chinese corporates often engage in guaranteeing or lending to other corporates. Guarantees range from non-binding letters of comfort to enforceable guarantees with the existence of these guarantees often undisclosed. The potential for one corporate default to trigger a wave of others is a known unknown.

Third, corporates have engaged in substantial margin lending of their own stock. One-third of A share companies have pledged more than 20% of their stock for loans, a substantial risk in itself. Yet this is made far worse when some of the companies pledging shares have little or no profit or are trading on P/E ratios above 100. The potential for a stock market crash to trigger widespread margin calls is a known known.

Chinese Banks and Shadow Banks

It's often forgotten that China is still an emerging market in many characteristics, with the quality of credit assessment one of those. Credit assessment in China is often based on connections and the prospective return, rather than a thorough assessment of cash flows and collateral. Whilst the default rate has ticked up this year, it remains unusually low by international standards as weak borrowers are allowed to rollover their debts. Chinese banks continue to lend to marginal state owned entities and the shadow banking sector continues to support speculative private sector borrowers.

The bank and shadow bank sectors are linked in two key ways. First, banks often package, sell and guarantee shadow bank products, typically selling them to retail buyers as a higher return alternative to bank deposits. Second, banks provide leverage to shadow bank products in order to increase the product's headline return. When China faces its first material test of lending standards since the 1990's, the transmission mechanisms between banks and shadow banks will allow defaults to quickly spread. The prevalence of short term lending will also serve as an accelerant.

The Main Driver of Dodgy Debt

It's frequently noted that recessions in the US typically occur after a series of Federal Reserve rate increases. The standard response is to assume that if rate increases were delayed or occurred at a slower pace then recessions could be avoided. This misguided thinking confuses cause and effect, ignoring the three ways that low interest rates encourage the build-up of dodgy debt;

(i) cheap debt allows a dollar of repayments to support a higher loan amount, allowing projects that wouldn't normally proceed to receive the go ahead, inflating economic growth;

(ii) cheap debt causes a short term, temporary increase in investment returns (valuations increase in long dated bonds, equities, property and infrastructure) leading some to underestimate investment risks;

(iii) the above two factors combine to drag down prospective long term returns, leading to yield chasing as investors shift from safer assets to riskier assets to meet return targets.

This process is evidenced by last cycle's credit and property bubbles in the US. After the 2002/3 recession began, the Federal Reserve reduced overnight rates to 1%, kick starting the cycle of yield chasing and malinvestment. By the time interest rates returned to neutral levels in 2006, speculative activity was widespread. Despite the obvious impacts of low interest rates in this and many previous cycles, central banks chose to set interest rates even lower and embark on quantitative easing in 2008. The alternative of a period of cleansing of excessive debt was deemed unpalatable. The inflated economic growth levels before the crisis were a benchmark that had to be exceeded. It's no surprise the US, Europe and Japan have all experienced unusually slow recoveries from the last crisis as the necessary debt cleansing process has been avoided or protracted.

Conclusion

In reviewing global debt, twelve sectors standout for their lax credit standards and increasing risk levels. There's excessive risk taking in developed and emerging debt, as well as in government, corporate, consumer and financial sector debt. This points to global credit being late cycle. Central banks have failed to learn the lessons from the last crisis. By seeking to avoid or lessen the necessary cleansing of malinvestment and excessive debt, this cycle's economic recovery has been unusually slow. Ultra-low interest rates and quantitative easing have increased the risk of another financial crisis, the opposite of the financial stability target many central bankers have.

For global debt investors, the current conditions offer limited potential for gains beyond carry. With credit spreads in many sectors at close to their lowest in the last decade, there is greater potential for spreads to widen dramatically than there is for spreads to tighten substantially. Keeping credit duration low, staying senior in the capital structure and shifting up the rating spectrum will cost some carry. However, the cost of de-risking now is as low as it has been for a long time. If the risks in the dirty dozen sectors materialise in the medium term, the losses avoided by de-risking will be a multiple of the carry foregone.