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Heat Wave: Rising Financial Risks in the United States

Author(s): Serkan Arslanalp, David Jones, and Sanjay Hazarika

Six years after the start of the global financial crisis, low interest rates and other central bank policies in the United States remain critical to encourage economic risk-taking—increased consumption by households, and greater willingness to invest and hire by businesses. However, this prolonged monetary ease also may have encouraged excessive financial risk-taking. Our analysis in the latest Global Financial Stability Report suggests that although economic benefits are becoming more evident, U.S. officials should remain alert to excessive financial risk-taking, particularly in lower-rated corporate debt markets.

From iMFdirect:

Bullish financial risk-taking bears monitoring

Persistently low global interest rates have prompted investors to search for higher returns in a wide range of markets, such as stocks, and investment-grade and high-yield bonds. This has resulted in escalating asset prices, and enabled issuers to sell assets with a reduced degree of protection for investors (we give you an example below). The combined trends of more expensive assets and a weakening quality of issuance could pose risks to stability.

 

To track the changes in financial risk taking since the crisis, particularly in the lower-rated corporate debt market, we developed a heat map that looks at signs of financial risk taking from three angles: valuation, issuance trends, and redemption risks.

MCM Heatmap

The heat map shows that financial risk taking in corporate debt markets is rising and markets have begun to overvalue many assets. Spreads in the high-yield and leveraged loan markets are not far from levels seen before the financial crisis. The quality of new loans issued is also declining, especially in the leveraged loan market where the amount of leverage in new deals is rising. The number of “covenant-lite” deals which give lenders less control over issuers has increased. For example, many new deals allow borrowers to issue more debt in the future without obtaining prior permission from lenders.

Meanwhile, the risk that many investors could sell their holdings all at once is now even higher than before the crisis.  Mutual funds, exchange traded funds, and households hold about 30 percent of corporate bonds  as of the end of June 2014.The worry is that such  “retail” investors could start selling suddenly if the value of their assets deteriorates unexpectedly.

For example, high-yield corporate and emerging market bond markets saw large retail outflows in May and June 2013, when investors panicked during the “taper tantrum” episode. That event was relatively short-lived and did not involve institutional investors.

A more severe episode of flight from risk by retail investors could lead to even greater financial volatility with wider systemic repercussions than were suffered during the 2013 event.

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