JAPANESE YEN, LEVERAGE LOANS, FEDERAL RATE HIKES – TALKING POINTS
- Japanese yen outlook bullish on ‘high’ risks in $3 trillion leveraged loan market
- The low interest rate regime has prompted companies to issue and buy high yield debt securities
- Fed rate hikes on the horizon could undermine credit-dependent lending stability
The Japanese yen could get a boost if market-wide risk aversion grips investors amid turbulence in the US$3 trillion leveraged loan market. With the Fed intent to raise rates in 2022 and halt its bond-buying program, loans made under an easy credit regime could be in trouble. As a result, the attractiveness of the anti-risk yen and the safe-haven linked US dollar could increase.
LOW INTEREST RATES HAVE FUELED THE BOOM IN THE CORPORATE DEBT MARKET
To avoid a credit crunch during the pandemic, the Fed has moved aggressively to suppress rising yields via rate cuts and unprecedented quantitative easing (QE). The Fed bought higher quality corporate debt in addition to more routine spending on Treasuries and mortgage-backed securities to ease liquidity concerns.
Monetary authorities took another unorthodox move: the Fed expanded its asset purchase program to include junk bonds, which have a comparatively higher probability of default. It should be noted that the central bank only bought so-called “fallen angels” – bonds with high credit ratings before the pandemic that were downgraded afterwards – and not debt that was lower quality. to investment grade before the virus outbreak.
In addition to buying corporate debt in the secondary market, the Fed also bought structured ETFs to provide exposure to junk bonds. While this helped ease liquidity issues as expected, it also worsened the multi-year trend for companies to issue increasingly risky debt securities in growing volumes. A OECD report from 2 years ago found that:
“Just over half (51%) of all new investment grade bonds in 2019 were rated BBB, the lowest investment grade rating. During the period 2000-2007, only 39% of investment-grade issues were rated BBB… In 2019, only 30% of global outstanding non-financial corporate bonds were rated A or better and issued by companies in the advanced economies.
When interest rates were low — or in some cases, negative — investors starved themselves for yield. Naturally, risky corporate debt was an investment avenue to cut back on, as the roads were paved with easy credit. However, the prospect of higher rates, combined with poor underwriting standardsmeans this road is likely to be a lot bumpier.
Legendary investor and co-founder of Oaktree Capital Management Howard Marks wrote about this credit-debt sequence in his book Mastering the market cycle. According to his analysis – which echoes the broad consensus of market macroeconomists – a period of jubilation is frequently followed by a period of interim. In this range, high volatility often boosts safe havens and anti-risk assets.
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It’s like musical chairs: everything is fine until the music stops and you find yourself without a chair. Adding to the metaphor: the bigger they are, the harder they fall. A recent report from the Federal Reserve Board, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency reinforced these concerns.
Officials found loans with “weak structures” that include aggressive repayment schedules, weak covenants and high leverage. The Fed isn’t the only one sounding the alarm. Earlier this month, European Central Bank (ECB) Supervisory Board Chair Andrea Enria warned banks that authorities will increase capital requirements unless they reduce loan exposure high risk.
FEDERATION RATE HIKE PLANS LIKELY TO FUEL VOLATILITY
At the Fed’s last meeting in January, the Federal Open Market Committee (FOMC) kept the federal funds rate within the 0-0.25% range. However, with high inflation figures over several decades, the Fed also signaled incoming rate hikes and an intention to aggressively reduce its balance sheet.
Some board members, like James Bullard, have advocated what many see as a bold approach: a full percentage point in rate hikes over the next three FOMC meetings. This means that at one of these meetings, the target rate would increase not by the usual 25 basis points, but by double, or half a percentage point.
With investors accustomed to ultra-loose credit terms – and many variable-rate loans issued during this period – a sharp rise in yields could have a ripple effect. Additionally, with higher borrowing costs and a slowing economy, companies with already thin profit margins and high debt loads are becoming increasingly vulnerable to default.
Non-banking and financial institutions exposed to these loans will then be required to take losses on debts that offer little or no protection to the lender. These so-called “covenant-lite” loans constitute the bulk of the corporate debt that has been issued in recent years.
WHY DO FX TRADERS GET CARE?
Volatility in credit markets has historically been shown to trickle down to other asset classes. Although past performance is not indicative of future results, the data provides a compelling narrative. Overlaying a correlation-weighted currency index of the Japanese yen with a credit default swap (CDS) tracker of below-investment-grade corporate debt in Europe shows a significant relationship.
When credit spreads widened sharply – meaning investors demanded a higher return for the increased risk of default – the Japanese yen generally appreciated against a basket of other currencies. In these types of scenarios, investors have prioritized minimizing losses over generating returns amid episodes of market-wide risk aversion.
Going forward, the addition of idiosyncratic shocks – such as the conflict in Ukraine – to the risks associated with Fed tightening could exacerbate this dynamic. To protect against future volatility, traders may increase their exposure to lower-yielding liquid assets at the expense of comparatively riskier, higher-yielding securities. In the G10 FX space, the Japanese yen is generally in such circumstances.