Asian debt surge signals rising risks, not necessarily a new crisis
As the US Federal Reserve prepares to tighten rates policy, region’s markets should brace for fallout as global capital re-prices high-yield risk
As the Federal Reserve prepares to tighten as early as this summer, markets around the world are bracing for the fallout. Photo: AFP
The prospect of higher US interest rates combined with weakening currencies across much of Asia is putting investors on edge after a high-yield bond issuance spree in recent years.
Some predict we are heading for another Asian financial crisis as mismatched currency and debt obligations again collide.
While there are similarities in excessive debt accumulation by corporates today and two decades ago, this is largely as far as it goes. A key distinction is the Asian financial crisis had its roots in Asia and was small enough to be contained in the region.
Today’s potential crisis can be traced back to the US, when it first set interest rates at near zero six years ago. As the Federal Reserve prepares to tighten as early as this summer, markets around the world are bracing for the fallout. This time around Asia is more likely to be collateral damage as global capital re-prices risk, particularly at the high-yield end of the market.
Although direct comparisons with the Asian financial crisis may be wide of the mark, the extraordinary growth in Asian high-yield debt in the past six years merits special attention.
Last year Asia-Pacific (ex Japan) accounted for US$35 billion of new issuance, almost six times the levels of 2009. By the end of 2014 there were more than 250 high-yield G3 corporate bond issuances in the Asia-Pacific region, with a principal value exceeding US$93 billion.
This growth was in part a response to a corporate funding gap after the Lehman Brothers crisis. Despite generational low interest rates, risk-adverse banks were highly discriminatory in their lending. If you were a large, well-regarded corporate, banks would queue up to lend at sub 5 per cent. But for everyone else in the corporate world the alternative might be a hedge fund lending at 15 per cent to 20 per cent. In mainland China the borrowing gap was often even more acute.
But after this impressive growth, we are now at a juncture in the high-yield bond market as tailwinds reverse. Typically, high-yield bonds tend to do well in a period of stable economies, stable interest rates and currencies, which has generally been the case in recent years. In the three years up to the middle of last year you could pick just about any high-yield name and have made money.
These benign conditions are now receding one by one, meaning investors need to be more cautious. Beyond divergence in interest rates – 21 central banks have already cut interest rates this year as the Fed prepares to raise rates – there is a noticeable decoupling across the global economy. From sharp slowdowns in economies’ growth rates, to steep falls in commodities including oil, as well as heightened currency volatility.
Although high-yield bond defaults are historically extremely low, it is inevitable they will increase in under-stress sectors such as mining, oil services and property.
At least now compared to 20 years ago there is much less currency mismatch between funding and local currency revenue to trigger default.
Local banks are now the main providers of credit and lending in local currency. There are some exceptions, however, such as mainland property where revenues are largely domestic.
Unfortunately if we do get to the stage of defaults, investors will find that creditor rights in Asia have not progressed in the past 20 years.
These are generally weak outside the mature markets of Japan and South Korea and recovery rates will be lower than the US and Europe.
This should act as a reminder that high-yield bonds investors are in fact putting their money at risk. There is no “free lunch”, especially at this point in the cycle. Anyone holding high-yield paper in a mainland property developer must appreciate they own a high-risk investment.
We expect the market to become increasingly selective and fundamental as liquidity becomes less of a driver. For example, investors in mainland property want to know not just the size and city of a developer’s land bank, but also if it is located downtown or is a speculative piece of farmland.
It might appear as fresh quantitative easing in Europe again sends bond yields to historic lows that liquidity always trumps all. But ultimately cheap money cannot work forever – interest rates can only go up from here. Investors need to prepare for that now.
Michel Lowy is co-founder and chief executive of SC Lowy