Let’s raise some debt and fuel speculation (Part 1 of 4)

Introduction

The maturity of a nation’s bond market plays an important role in the financial intermediation of an economy, according to the IMF (WP/05/57):

As we have argued, prudent management of government debt is important to safeguard fragile domestic banking systems. But financial development in the long run benefits greatly from moving beyond a purely bank-based system to include not only a stock market but also a long-term private bond market.

The entrenching role of debt has gone unnoticed, like the air we breathe, good quality corporate debt has been taken for granted. Society is now gasping for a breath of fresh air. The subprime mortgage scandal in 2007-2008 was an opportunity to recapitalize the financial system and get to grips with the extent to which we were geared. Although equity valuations around the world plummeted amounting the loss of confidence, we rolled over on the opportunity to reform and consequently doubled-down on leverage.

So the question needs to be asked: what induced the introduction of more debt? Central bankers, in the interest of our welfare-maximizing state, purported to perform large-scale asset purchases, also known as ‘Quantitative Easing’, results of which can only be established ex-post in the coming years.

Recent literature recognizes the key role debt plays in 21st century financial intermediation. Globalization means trade and money flow seamlessly cross borders and time zones, resulting in a global economy which never rests. As a result, contagion will continue to be one of the greatest risk management tools the government of any developed nation needs to maintain in order to prevent spill over and effects from capital flight.

A major risk management tool of advanced economies is debt, specifically government bonds.

Government bonds are the backbone to society: an asset class which institutional investors hold in the nation’s currency – the bond is a principal investment and pays coupon payments in the denominated currency over the term of issuance. Furthermore, government bonds are riskless so long as holders believe the probability a government will unwillingly default on its obligations is incomprehensible.

This can only be held under two assumptions: Firstly, future cash flows from tax revenue can maintain coupon payments and secondly, more debt can be raised to pay off current debt obligations. This means government debt serves and gets treated as collateral to financial intermediation.

Further from the IMF working paper:

A government debt market does this first by putting in place a basic financial infrastructure including laws, institutions, products, services, repo and derivatives markets, and second by playing a role as an informational benchmark. A single private issuer of securities would never be of sufficient size to generate a complete yield curve, and his securities would not be nominally riskless because only the government has the power to print domestic currency.

If a complete yield curve depends wholly on a deep and liquid bond market, the speed by which a bond market is developed is most important. Underwriting fees of investment banking arms move in-line with the rate of bond and equity market development. So long as more debt and equity is issued or restructured, underwriting fees will result. Some would consider this a conflict of interest between the profit-seeking of investment banks and the social stability of financial development.

Let’s then consider the pace of bond market development, from a 2016 Standard & Poor’s Report,

The world has amassed debt at a faster pace than income growth since the 2008-2009 financial crisis. That pace contrasts greatly between developed and developing economies… Globally, the increase in debt has outstripped income growth, with Asia and Latin America far outpacing Europe’s and North America’s low rates. In terms of corporate debt, the very high borrowing of Chinese and Hong Kong corporates amid China’s economic slowdown poses a prominent risk. A less obvious risk is the increased concentration of U.S. corporate debt among ‘B’ or lower speculative-grade issuers.

In fact, the prospect of rising defaults in China is only one of the two largest risks to global corporate credit, as the surge in leveraged finance in the US is the second, according to S&P Rating Services. Having reached 10.6% in 2010, China’s economic growth has contracted consistently year-on-year, registering 6.9% in 2015. Nominal GDP growth is one proxy for debt demand.

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The S&P project $71 trillion of global corporate debt to be outstanding in 2019. This resulted from a $57 trillion demand for corporate debt from 2015 to 2019, of which $37 trillion was refinancing and $20 trillion new debt. This projection is a 4% drop from last year and projects $11.4 trillion of debt being issued each year through 2019.

Of the $71 trillion S&P project to be outstanding, Chinese corporate debt is expected to represent 40% or $28.4 trillion. This suggests China’s “capitalism with Chinese characteristics” relies upon corporate debt as the fuel for its economic growth, at least numerically. In fact, China’s corporate debt now stands 8x the size of Chinese government debt and is also the largest in the world.

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To put into perspective, the compound annual growth rate of corporate debt issuance in the U.S. has been in the region of 3-4% per year – a textbook example of the rate at which a bond market should be developed (depicted below).

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The S&P note that the trend of issuance has been twofold. Firstly, investment grade (greater than BBB-) issuers in the US have been issuing cheap debt and then hoarding the proceeds as cash offshore. For example, Apple’s cash position amounted to nearly 10% of corporate America’s cash, according to the Financial Times. The cash position of non-financial companies in the US amounted to $1.73 trillion, according to Moody’s, but nearly two-thirds of this is left abroad due to taxation. Secondly, quantitative easing by the Fed has allowed speculative grade (lower than BBB-) issuers to pay down previously held debt obligations by issuing lower cost debt. In this case, the S&P raises concern over the high indebtedness of US corporates against US leveraged finance borrowers.

In contrast to the US, the Chinese Renminbi bond market remains in infancy, despite its vast size. Analysts have voiced their concerns on the divergence between the rate of economic growth and corporate bond issuance in China. Corporate debt issuance has climbed in the last five years while the rate of economic growth in China slowed to its lowest pace in 25 years, albeit still standing 3-4x greater than the U.S. and most of Europe. Analysts are concerned with the ability to repay debt obligations, specifically if corporate earnings aren’t able to keep up with debt service payments, a vicious cycle of defaults would begin. In this case, an intervention by the Chinese authorities would be the lender of last resort, preventing contagion to Chinese equity markets and spilling over to global valuations.

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The above graph depicts the growth of bonds outstanding in China (corporate as orange and government as blue) against the year-on-year growth rate of corporate bonds. The issuance trend grew considerably until just after the subprime mortgage scandal, after which the growth rate has moderated into stable double-digit territory. China’s bond market now stands as the 3rd largest in the world, following the U.S. and Japan.

What is the driving force for bond market development? In order to diversify the risks associated with and to establish a modern financial system, the Chinese government has recognized that a bond market alleviates the pressure on Chinese companies from being restricted to equity raising and bank loan financing. Bond issuance effectively substitutes away the risk from the banking system and into investors hands, currently domestically but eventually internationally.

However, the rapid debt growth, opacity of risk and pricing, high debt-to-GDP, and uncertainty surrounding Chinese equity markets continue to pose as significant risks. Another concern surrounds the role state-owned enterprises continue to play in the Chinese economy. According to the Asian Development Bank (table below), the top 30 issuers of corporate bonds in China are either state-owned enterprises are strongly connected to the Chinese government via consolidated ownership:

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These 30 issuers compromise 40.8% of the total corporate bond market, and since these issuers are either state-owned enterprises (SOEs) or connected to the Chinese government, the state must continue to be invested in the financial stability of the economy. This is of concern since SOEs tend to show credit metrics about half as strong as non-SOE peers, according to the S&P. Diversification of ownership is necessary in order to spread the risk among participants of the financial system.

The table below shows the large state-concentration of holdings in Chinese government bonds and corporate bonds, albeit the ownership division is more diversified for Chinese corporate bonds:

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