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Corporate loans pose real risk to markets, UBS Asset Management says

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trader staring screen
Traders
work on the floor of the New York Stock Exchange (NYSE) in New
York, U.S., July 18, 2018.

Brendan
McDermid/Reuters


  • The big risk UBS Asset Management sees in financial
    markets can be found in the corporate-loan
    market. 
  • A large proportion of corporate loans are
    floating-rate, meaning that paying them back will be more
    expensive as interest rates rise. 
  • Even though banks are better capitalized to handle
    defaults relative to the Great Recession, the crisis has
    lowered investors’ ability to tolerate another credit
    crunch.

There’s plenty of debt in the financial system: in households, on
corporate balance sheets, and on the US government’s books. 

But none of these are as troubling to UBS Asset
Management as corporate debt, which adds up to a
record
 $6.3 trillion, according to S&P Global.

“Where I think the real risk is now is in the corporate-loan
market,” Erin Browne, the head of asset allocation at UBS Asset
Management, said at a media roundtable on Friday.

A large share of these loans are floating rate, she added,
meaning that they get more expensive to repay as interest rates
increase. What’s interesting, Browne said, is that many of these
loans are short-term and will mature by 2021 or 2022, when the
Federal Reserve would have increased interest rates several more
times for this cycle. 

UBS Asset Management’s recession-probability monitor places the
odds of a downturn within the next year at 15%. And so, while
corporate borrowing is a risk the firm is watching, it’s not one
that’s expected to rattle financial markets anytime soon.

UBS’ probability monitor gets concerning above 33%, and stands at
a 45% chance of recession in the next three years, Browne
said. 

A decade after the financial crisis, the rising level of leverage
in the financial system has become a recurring concern. In its
2018 economic outlook, the
Bank for International Settlements
, also known as the bank
for central bankers, recently warned that corporate leverage was
contributing to a
debt trap
that would be hard to escape as borrowing costs go
up. 

The real trouble could arise when these corporate loans come due,
according to Barry Gill, the head of active equities at UBS
Asset Management.

After the last financial crisis, banks changed the due dates for
some businesses that were struggling to repay on time. This
practice, known as extend and pretend, may be less tolerable
because of the burden it places on the same financial
institutions that almost went bust and had to be bailed out after
the recession.  

“Banks have materially more capital this time around,” Gill said.
“The problem is that the appetite for tolerating an erosion of
that capital base in the next downturn at the banking system
level is far less than the tolerance level was in ’07 or ’08.”

To hedge against risks that may stem from credit markets, UBS
Asset Management is long equities, short high-yield, and
underweight investment-grade bonds. This isn’t because the firm
believes defaults will start picking up soon, but because
valuations are expensive, Browne said. 

UBS is also
bullish on commodities
as this cycle wraps up.

“As you get into late cycle, what does the best in terms of all
asset classes on a both absolute and risk-adjusted basis is
commodities,” and UBS is playing this through energy, Browne
said.   

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