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A Wall Street firm calculated exactly how deep losses will be if the swelling debt bubble bursts - and its findings paint a grim picture for the market's future

Business Insider | Jun 10, 2019, 07.05PM IST

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Reuters/Jeenah Moon

  • UBS recently laid out potential catalysts and uncertainties surrounding a credit crunch that could befall markets as soon as 2020.
  • The firm also looked at different parts of the debt market and calculated how deep losses will be in the event of a debt-market squeeze and corresponding downturn.
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Investors have been dealing with a capricious trading environment of late as trade war escalations, geopolitical uncertainties, and lackluster economic data slowly erode the last inklings of investor optimism.

To add insult to injury, a prominent Wall Street firm is now sounding the alarm on trouble brewing elsewhere: the credit market.

"Our core view is that low global interest rates and quantitative easing globally have driven a sustained expansion in the riskiest forms of corporate debt," UBS strategist Matthew Mish wrote in a recent client note.

Mish set the stage for preemptive action prior to the second quarter of 2020, the earliest point at which he says a vicious credit downturn could strike. The culprit? Irresponsible issuance on global central banks' easy-money policies.

UBS thinks those banks artificially and unnecessarily provided the fodder firms then used for risky debt financing. And all the while, the quality of these issues declined.

This dynamic can be seen in the chart below. The dark red line reflects the degree to which non-financial corporate debt has risen relative to gross domestic product.

Screen Shot 2019 06 07 at 9.31.23 AM

UBS

Currently, the level of corporate debt to GDP is hovering near record levels, prompting prominent market figures to sound the alarm on the risk of defaults. This key ratio's wellbeing will likely be in jeopardy if the US grows at a slower-than-expected pace, stifling confidence as debt downgrades and defaults send investors rushing towards the exits.

Futher, although debt levels and growth are important, the quality of the issuance carries a significant amount of weight as well.

UBS sees the stealthy, surging level of speculative grade (or "junk") bond issuance as a glaring concern. Although these securities carry higher interest rates - something investors have been clamoring for - they also come with exponentially more risk in the form of a greater chance of default, and less liquidity.

Even the higher-quality portion of the debt market is under significant pressure. As the chart below shows, the share of investment grade debt that sits on the lowest rung of creditworthiness - or those bonds with BBB ratings - is near the biggest it's even been.

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Bond comp

To that end, UBS crunched the numbers around how bad conditions can get. The firm split its analysis up into different segments of the bond market. And the conclusions are jarring:

Lower rated (B, CCC) - Leveraged loan losses of 7%, and 50% recoveries.

Middle market/private credit - Losses of 11-12%, 19% defaults, and 40% recoveries.

US high yield - Losses of 7-7.5%, 10% defaults, and 25-30% recoveries.

Overall - 7-12% losses on $3.3 trillion of speculative grade debt, resulting in $280 billion of annual losses.

These risks are not lost on the experts who control the financial system. In an attempt to quell investor anxiety, Federal Reserve Chair Jerome Powell stated "business debt does not appear to present notable risks to financial stability."

He added that the riskiest classes of debt are "funded principally nonbank lenders." So, although there is increasing leverage in the system, this isn't another 2008.

Going forward, imbalanced institutions that once rode the coattails of QE will now face an increasingly difficult environment as central banks provide less and less stimulus. Couple this notion with a potential negative shock to earnings, via an escalation of trade tensions, and you've got a recipe for a credit crunch.

It's hard to say exactly when this phenomenon will actually take place, given the the seemingly daily shifts in investor sentiment. However, it's never a bad idea to be prepared.

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