The scramble in debt markets

It is now widely acknowledged that the pandemic has unleashed a global debt "tsunami". 

The total level of global indebtedness has increased by $15tn this year, leaving it on track to exceed $277tn in 2020, said the IIF, which represents financial institutions. It expects total debt to reach 365 per cent of global gross domestic product by the end of the year, surging from 320 per cent at the end of 2019. Debt burdens are especially onerous in emerging markets, having risen by 26 percentage points so far this year to approach 250 per cent of GDP, the IIF said. The share of EM governments’ revenues spent on repayments has also risen sharply this year, according to IIF data. This week Zambia became the sixth developing country to default or restructure debts in 2020. More defaults are expected as the cost of the pandemic mounts... Debts in advanced economies rose by more than 50 percentage points this year to hit 432 per cent of GDP by the end of September. The US accounted for nearly half of this; its debts are set to reach $80tn this year, from $71tn at the end of 2019.

This is only the latest in the series of triggers over the last three decades which have resulted in a steady rise in global indebtedness. 

Morgan Housel writes about how the Fed's actions since the GFC have upended conventional wisdom among investors,

The Federal Reserve learned how to keep the financial system from falling apart. That’s both kept a lot of the economy humming and ruined a lot of assumptions people had about how the economy works... In 2008 Bernanke, as Fed chairman, flooded the financial system with an unprecedented amount of liquidity. It worked, which is why we call 2008 the Great Recession and not the Second Great Depression. It also paved the way for Bernanke’s successors to open the monetary floodgates when the economy tumbles... people have a new set of expectations about what the Fed can and should do... a lot of what we thought we know about what economies do during recessions has been upended.

I would only qualify everywhere with "appeared to have been upended", atleast for some time. How much longer will the appearance persist is the point. 

Finance 101 teaches us about the disciplining powers of debt. Equity holders feel that the need to service debts incentivises effective management by executives. Lenders too are comforted by the legal structure that protects their interests.

But over the years, these assumptions have come under attack, thereby weakening debt's disciplining powers.

Consider some. One, the binary between equity and debt has been replaced by a continuum of cash waterfall, from equity to the junior most debt, with everything in between being some or other form of debt. Not only is this waterfall complex, with a bewildering array of complicated and opaque conditions behind the priorities, the seniority preferences also change with time.

Second, banks and bond markets are no longer the only providers of debt, with banks in particular having receded due to increased post-crisis regulatory oversight. Private debt is occupying an increasing share of the debt market. They jostle for space in the continuum between equity and senior most debt. They do not have legal protections that have historically been a feature of debt. The share of covenant lite loans are at historic highs.

Third, the persistence of abundant cheap capital, complex financial engineering, and emergence of private debt providers have made it easier for firms to leverage up excessively. Policies like tax deduction on interest expenses too favour leverage. Unsurprisingly, the shares of leveraged loans and aggregate leverage are at historic levels. The share of zombie companies too have reached alarming levels.

Four, amplifying all these distortions and creating more are the actions of central banks to keep rates at zero bound for an extended period of time and backstop the equity and debt markets, including through outright purchases of sovereign and corporate bonds.

One manifestation of the problems associated with these trends is being played out in the private equity market. As the share of private debt has grown in a market unrestrained by any regulatory restraints, private equity firms are suddenly finding that they are at the receiving end of practices that they used to inflict on others. The FT has an article which chronicles them,

Reaching for new funds to see it through the pandemic, mattress company Serta Simmons Bedding took $200m in new loans from a slim majority of creditors who, in addition to putting in the fresh money, saw their existing loans move up in seniority in the capital structure. Holders of the other 49 per cent of Serta’s loans, including Apollo, effectively had their claim on the company’s assets become subordinated to the favoured debtholders. Apollo sued, alongside other disgruntled creditors including Angelo Gordon and Gamut Capital. In a tart response, Serta, owned by private equity group Advent International, noted that the claimants had “sponsored and participated in numerous transactions structured similarly to this transaction”. A New York judge denied Apollo’s attempt to halt the deal.

Private equity funds are realising that payback happens in unexpected forms, and everyone is in the same boat,

In the Caesars case, for example, where Elliott Management, founded by ex-lawyer Paul Singer, owned $1bn worth of debt, had filed a lawsuit accusing the Caesars’ co-owner, Apollo, of “unimaginably brazen corporate looting” for selling casinos that creditors including Elliott believed had belonged to them. (Elliott eventually settled with Caesars and Apollo)... Elliott... now finds itself in the crosshairs of credit hedge funds that bought one of its portfolio company’s debt. Travelport, a booking software company acquired by Evergreen and Siris Capital, has been accused by existing lenders of “asset stripping” after it secured $500m in debt financing from its two owners to ease a liquidity crunch, in a deal that moved intellectual property collateral away from other creditors. Travelport selected the Elliott/Siris financing over a proposal from existing creditors including Blackstone’s credit arm, GSO, and, in the face of grumbling from the aggrieved side, Elliott has asked a New York state court to affirm that the transaction is proper. Ironically, Blackstone had previously owned Travelport, taking money out of the company in 2007 through a dividend recapitalisation that sparked a clash with bondholders in 2011.

The GFC led to tightening of regulations on banks, which insulated them from certain damaging trends in the debt market. The non-bank and alternative capital debt markets have in turn risen to take the place of banks. But as the size of private debt market has grown and its systemic effects more evident, questions are being raised about the need for its greater regulation. In a world economy where balance sheets of corporates and financial institutions are both overladen with debt, troubles in any part of the credit market can generate an amplified response.

A BIS study found that even something more regulated like the corporate bond markets, with its innate illiquidity, can freeze up suddenly, as happened in early March this year. This, as the FT writes, can have consequences across the markets,

“Issuance in primary markets stopped, mutual funds saw sizeable outflows, and secondary market yield spreads to government securities widened very rapidly,” the BIS says... Worse, the ETF market went haywire — seemingly confirming the fears. Most notably, in early March, the price of ETFs collapsed so dramatically that the funds lost their link to the prices of the underlying corporate bonds. Some traded at a 5 per cent discount to the value of their underlying assets, in the most extreme moments of dislocation. That seemed utterly bizarre at the time. However, analysts have subsequently re-examined events with cool heads and two curious points emerge. These are that ETF price swings preceded other market moves, albeit in a more extreme way. Plus, this volatility did not occur because trading dried up; on the contrary, daily ETF trading volumes exploded, running 250 per cent higher than before the crisis, and investor redemptions were very modest in March compared with other asset classes. Thus, it seems that investors reacted to the corporate bond market freeze by using ETFs to hedge risks, conduct price discovery and dump exposures they disliked. ETFs were thus an investor crutch, not a market block.