David Fuller and Eoin Treacy's Comment of the Day
Category - General

    Leveraged loans: how much do credit ratings understate the risks?

    Thanks to a subscriber for this report from UBS which may be of interest. Here is a section: 

    Two of the main arguments against higher loan defaults are lower rates and lack of covenants. On lower rates, we believe the transmission mechanism of lower rates to leveraged loans is comparatively weak. Our recent work has shown that LL yields are little changed year-over-year, in part because wider spreads have offset modest declines in LIBOR rates. Looking ahead, 4 rate cuts in 2020 could help loan issuers but there are likely offsetting factors. One is that this assumes loan spreads do not widen, which we think is unlikely, particularly heading into 1H20 with US GDP growth slowing to 0.3-0.5% in 1H20. Two is if rating agency downgrades persist (as we expect) the future cost of new funding for issuers increases substantially with each rating notch; our analysis shows the current spread differential between a B- and a CCC+ loan is c300bp. Three is that the Fed has less room to stimulate: only 38-52% of the rate relief provided in the last two cycles. 

    On lack of covenants, the key driver of defaults historically is not covenant violations but insolvency and illiquidity. One of the more holistic papers compares these factors in triggering defaults and argues that low market asset value to debt is the key driver while, on average, covenants add limited additional information4. We believe lack of covenants will change the event of default, with more distressed exchanges likely. But it is not clear this is a good outcome. Covenants had weakened leading up to the '15-16 energy default cycle, yet default rates were elevated (peak 22%) and many distressed exchanges failed with roughly half of firms re-defaulting. While loan downgrades to CCCs have been lagging those to B-, we are starting to see more evidence of downgrades to CCC. These decisions are primarily driven by weak operating performance, negative cash flow and capital structure unsustainability (even as issuers do not have maturities until 202022). Once a firm is downgraded to CCC, we believe the re-pricing in loan yields makes distressed exchanges likely, particularly in more stressed markets.

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    China Braces for Sub-6% Economic Growth in Key Policy Meetings

    This article from Bloomberg news may be of interest to subscribers. Here is a section: 

    “They measure the policy scope by looking at the overall debt, by looking at how much risk there is in shadow banking, in the housing sector and in inflation,” Yao said. “Looking at all these things, they judge they actually don’t have much scope from a long-term perspective. So they’re very careful about how to use it and when to use it.”

    With few major monetary policy moves in the past month, the Loan Prime Rate, a market gauge of borrowing costs, remained unchanged in October, according to a PBOC release Monday.

    In his statement to the IMF’s steering committee at the meetings, Yi said that growth had been stable this year and the “main economic indicators kept within an appropriate range.” While keeping credit growing, the bank should also pay attention to “maintaining a stabilized leverage ratio,” he said.

    Yi won support for China’s approach from the IMF, which otherwise has been urging more action to support the global economy. Kenneth Kang, deputy director of the fund’s Asia and Pacific Department, said any support to prop up the Chinese economy should be “contained, calibrated to the shock, it should be temporary in nature and it should be focusing on re-balancing growth down the road.”

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    US military report recommends giving AI autonomous authority to launch nuclear weapons

    This article by Matthew Griffin may be of interest to subscribers. Here is a section:

    In other words, they want to give an AI the nuclear codes. And yes, as the authors admit, it sure sounds a lot like the “Doomsday Machine” from Stanley Kubrick’s 1964 satire “Dr. Strangelove.”

    The “Dead Hand” referenced in the title refers to the Soviet Union’s automated system that would have launched nuclear weapons if certain conditions were met, including the death of the Union’s leader.

    This time, though, the AI-powered system suggested by Lowther and McGiffin wouldn’t even wait for a first strike against the US to occur — it would know what to do ahead of time.

    “[I]t may be necessary to develop a system based on artificial intelligence, with predetermined response decisions, that detects, decides, and directs strategic forces with such speed that the attack-time compression challenge does not place the United States in an impossible position,” they wrote.

    The attack-time compression is the phenomenon that modern technologies, including highly sensitive radar and near instantaneous communication, drastically reduced the time between detection and decision time. The challenge: modern weapon technologies, particularly hypersonic cruise missiles and aircraft, cut the window even further.

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    These Are the World's Best (and Worst) Pension Systems

    This article by Matthew Burgess for Bloomberg may be of interest to subscribers. Here is a section: 

    The study comes as policy makers grapple with more people entering retirement, living longer and needing a steady flow of income on which to survive. Almost one-fifth of the world’s
    population is forecast to be of retirement age by 2070, up from about 9% this year, United Nations data show.

    “Systems around the world are facing unprecedented life expectancy and rising pressure on public resources to support the health and welfare of older citizens,” said David Knox, the report’s author and senior partner at Mercer. “It’s imperative that policy makers reflect on the strengths and weaknesses of their systems to ensure stronger long-term outcomes for the
    retirees of the future.”

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    Chinese Nuclear Stockpile Clouds Prospects for U.S.-Russia Deal

    This article by David Wainer for Bloomberg may be of interest to subscribers. Here is a section:

    Russian officials say they want the current agreement extended for the allowed five years beyond its 2021 expiration. Foreign Minister Sergey Lavrov told reporters last month that that the U.S. continues to insist China be brought into negotiations, a message he said Secretary of State Michael Pompeo delivered to him at the annual United Nations General Assembly meetings.

    But Moscow says time is running out. Negotiations for a new deal would typically take as long as a year. Even settling on an extension would be lengthy.

    “We urge our American colleagues not to lose time anymore,” Russian Deputy Foreign Minister Sergei Ryabkov said in an interview with Russia’s International Affairs journal. “There’s almost none left. Simply letting this treaty die would be unforgivable. This will be perceived by the international community as neglecting one of the key pillars of international security.”

    Despite American efforts, Beijing has so far balked at trilateral talks, arguing it is far behind Moscow and Washington, which together hold more than 90% of the world’s nuclear weapons.

    “China has no interest in participating in a nuclear-arms-reduction negotiation with the U.S. or Russia, given the huge gap between China’s nuclear arsenal and those of the U.S. and Russia,” said Fu Cong, director general of the foreign ministry’s Arms Control Department. “The U.S. and Russia, as the countries possessing the largest and most advanced nuclear arsenals, bear special and primary responsibilities on nuclear disarmament.”

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