The IMF’s global financial stability report, released in October, once again drew attention to the build-up of speculative and at-risk corporate debt in large economies, notably the US and Europe.
Debt owed by companies whose earnings are insufficient to cover interest payments (debt-at-risk) and speculative-grade debt are already elevated in several major economies.
It is hardly news that in a world of repressed rates this risky credit has been underpriced and oversupplied.
However, the IMF now finds that, thanks to low-cost, easy terms and competition to lend, rising problem debt could soon exceed crisis-era levels should trade tensions and slowing growth lead to an economic downturn much milder than the one that followed the global financial crisis (GFC).
It wouldn’t take a wild decline in profits or rise in debt service costs for risky corporate debt in the US, UK and China to surpass levels seen in the GFC and to approach those crisis levels in France and Spain.
Add in weakening credit in Japan, German and Italy, and, on aggregate across those eight economies, debt-at-risk would amount to $19 trillion, or nearly 40% of total corporate debt, in the downturn the IMF models in 2021.
In a heroic piece of understatement, the IMF judges: “This is worrisome given that the shock is calibrated to be only about half what it was during the global financial crisis.”
Less attention has focused on a separate analysis the IMF has undertaken on problems that have been building up out of sight thank to investors’ willingness to take on not just greater credit and market risk but also greater liquidity risk.
The IMF finds that large pension funds have increased allocations to alternatives – some of them leveraged, many illiquid – from just over 5% of their assets on the eve of the GFC in 2007 to just over 20% today.
The lesson is clear: in illiquid markets, prices can gap down alarmingly when greed suddenly gives way to fear
Anecdotal evidence suggests that within the broad class of alternatives they have been reducing exposure to more liquid investments, such as hedge funds that have underperformed in recent years, and increasing allocations to illiquid ones, such as direct investments in unlisted equity.
A lot of money that used to invest exclusively or mainly in liquid, public equity markets has been chasing big early positions in the next Facebook or Amazon before they float.
As our feature story on WeWork shows, these have become crowded trades. Investors have been more concerned to allocate large sums to what they believe will be long-term winners than to do so at appropriate valuations.
In August, WeWork and its banks launched an IPO that valued the serviced office business above $47 billion. At the end of September, they pulled that deal. In mid-October, WeWork announced a rescue injection of equity that valued it at just over $8 billion.
Valuations may have been even more stretched in private equity than in public equity. It remains to be seen if WeWork marks a tipping point with much wider and even systemic implications.
However, the lesson is clear: in illiquid markets, prices can gap down alarmingly when greed suddenly gives way to fear.
The IMF points out that the exposure of pension funds to illiquidity risk will limit their ability to invest countercyclically and play a stabilizing role during coming periods of market stress.
Perhaps even worse, pension fund losses could transmit stress to sponsoring governments and to corporations by increasing their contingent liabilities.
That’s the danger with illiquid investments. Potential problems are disguised until, suddenly, they all hit at once.