A Warning Over Speculative Debt
Last week, the European Central Bank (ECB) raised a red flag, saying some member banks have ignored warnings of risks associated with leveraged finance, according to Bloomberg News. The ECB hit a handful of European banks with capital charges in an attempt to encourage the banks to exercise greater caution. These actions come amid growing concern in Europe over a looming energy crisis, ongoing war in Ukraine, and struggles at some financial institutions. These pressures are evident in both confidence indicators like business confidence (graph A, below) and measures of financial stress (graph B, below).
Graph A
Graph B
Rise of Leveraged Finance
Leveraged finance is the use of high amounts of debt, instead of equity, to purchase assets. This type of financing often aims to increase an investment’s potential return. An underlying assumption is that the investment increases in value faster than the cost of financing the investment. As interest rates rise and the economy slows, greater attention is likely to be paid to such arrangements. The Federal Reserve and other U.S. agencies have warned of risks associated with rapid growth of leveraged loans, especially those originated by hedge funds and others outside the traditional banking system.
An extended period of low rates, low volatility, and risk appetite drove a global hunt for yield, and easy monetary policies encouraged heavy borrowing. Private equity and leveraged buyout activity hypercharged growth, resulting in more leverage and less bondholder protection. According to Moody’s, leveraged finance is now $4 in size globally, with $1.5 trillion borrowed in 2021 alone.
Now, central banks around the world are pulling back support. Facing high inflation, they are raising short-term interest rates and reducing programs that previously supported market liquidity. Since leveraged loans feature floating interest rates, recent increases in short-term interest rates, in combination with a potential slowdown in earnings growth posed by the less favorable economic outlook, could pressure credit quality of highly indebted companies. In effect, central banks are looking to manage risks in leveraged finance now that they have removed the “punch bowl,” and toughening financial conditions potentially lie ahead.
Why Care?
We care about debt and leverage because they can amplify volatility. When a company or economy with high debt experiences a downturn or increase in borrowing costs, both of which are in the cards today, crisis and failure can easily follow. When debt burdens are lower, the business’s and economy’s periodic ups and downs are less life-threatening. Over the past decade, global debt increased by about 4.6% annually while the global economy grew an average of 2.7% per year, including inflation (graph C, below). Leveraged loans to lower-quality borrowers in the United States rose even faster, at a 12.2% pace, according to the Federal Reserve. The result was a rise in total global debt to nearly $150 trillion, about 50% more than the entire planet’s annual output (graph D, below). The potential for greater volatility, more shocks, and a rolling crisis is significant if debt continues to grow faster than the economy.
Graph C
Graph D
Conclusion
It is increasingly important to focus on quality in a world of growing debt burdens. Should the months bring lower earnings and higher funding costs, higher-quality companies with less debt should perform better than lower-quality, highly indebted companies. Companies with greater flexibility, predictability, and durability make sense in such an environment. Therefore, our focus on asset profitability, lean balance sheets, and steady businesses will remain foremost in our minds.
Disclosures:
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