Where is the risk in global financial markets?

Against this background there is clearly a risk of a disorderly weakening of the LBO market in the quarters to come, although it should be noted that leverage remains lower than in the 1980s. The transmission mechanism of any weakening in the LBO market would also likely be different to the 1980s - the financing of most LBOs in this cycle has been via loans rather than high-yield bonds, with many of these loans being repackaged and sold on to a professional investor base. This latter factor might mean a more dispersed impact in the case that considerable numbers of LBO loans start to turn bad.

...some segments of the corporate debt market...

Another closely related area of concern is the corporate debt market. The issue here is not so much the general level of corporate leverage, but rather the worrying evidence of deteriorating credit quality within corporate issuance. In the US, credit market debt/net worth in the corporate sector has declined significantly over the last few years, and although it has risen slightly as a proportion of GDP in recent quarters it remains somewhat below the last peak in 2001. In the UK, the debt/capital ratio has dropped if the latter is measured at market value, but has increased somewhat if capital is measured at replacement cost. Generally though, corporate balance sheets globally look relatively healthy, with interest coverage good due to high profitability.

A closer look at trends in corporate financing reveals some interesting - and in some cases disturbing - details. US corporate debt issuance rose to a record US$1 trillion in 2006, and was around US$400 billion in the first five months of this year. Notably, however, the growth of subinvestment grade issuance has been faster than the growth of overall issuance - and within the subinvestment grade sector there has been a growing share of the lowest rated paper. According to S&P, in the first five months of the year subinvestment grade issuance was around a fifth of total issuance (versus 13% in 2005) and the share of B- and CCC/C credit within this rose to over 43% (up from 36% in 2005).

Given this profile of issuance, it seems extremely unlikely that recent low levels of corporate defaults can be sustained. In 2006, the default rate in speculative debt was only 1%, and only 7% even in CCC- paper. Over a three-year horizon, though, the historical default rate for B- credits is 29% and for CCC and below credits 44%. This suggests that there is a significant risk that recent vintages of junk bond issuance could push up the overall corporate default rate sharply over the next few years. S&P estimates the default rate could rise to 2.3% in a year from the current 1.4%, well below the last peak in 2002Q1 (5.2%) but enough of a rise to potentially cause substantial losses among investors who have snapped up large volumes of this debt.

In the syndicated loan market the evidence of eroded credit quality looks even more alarming, with some 50% of issuance in 2007Q1 in the subinvestment grade category - up from less than 20% in 2000-2001. Credit standards have been slipping in other ways too - for example, via a reduced use of covenants on these issues (which could reduce the recovery rate for investors on defaulted loans).