by the BlackRock Investment Institute
We think global debt markets are in the process of undergoing a tremendous secular change that will make fixed income investing over the next five-to-ten years look very different from what it has looked like over the past twenty. Specifically, lower economic growth rates in the developed world, and very high current levels of aggregate system-wide leverage there, should place limits on the total amount of debt issuance from those countries.
Moreover, not only will developed market fixed income supply be less than it has been in the past (providing a technical tailwind to those markets), but demand for yielding assets from both developed market and emerging market institutions will continue to rise sharply at the same time, in part due to widespread demographic changes. This factor, as well as the relatively improved economic fundamentals amongst Asia-region issuers, and the higher rates of growth those countries enjoy, should meaningfully begin to shift fixed income supply from the developed markets to emerging markets (particularly in local currency denominated issues), with Asia region issuance being key to this change.
Figure 1: Comparing Capital Structures – More Debt in Developed Markets
We think economic growth is the most important factor to consider when looking at regional changes in debt issuance (at both the sovereign and corporate levels), and Asia-region credit growth, excluding Japan, may advance at a compounded annual growth rate of around 10 per cent to 15 per cent in the years to come. Moreover, this shift will appear particularly dramatic when regional differences in historical corporate capital structures are taken into account.
For example, the typical corporation in the Asia-ex Japan region has historically held a capital structure with a considerably greater weight in equity, with less debt than US or European counterparts (see Figure 1). In fact, bank loans have historically been the Asian issuers’ primary source of debt financing, representing approximately 10 per cent of the typical corporation’s capital structure, versus half of that level for the average US firm. Overall, total debt (both bonds and loans) represents nearly a quarter of US corporate capital structures, and around a third of the capital structure of a European company, yet despite trends toward increased issuance, it still only represents about 17 per cent of Asia company capital structures. The upshot is that not only has issuance increased recently, which aids in improving market depth and liquidity, but we believe this also represents the early stages of a transition to greater global emphasis on Asia debt markets.
According to Morgan Stanley research, fixed income issuance in 2011 may still come close to hitting record levels for the third straight year (see Figure 2), although recent market volatility presents a headwind. Placed in context, though, these issuance trends (which account for both sovereign and corporate debt) are off a relatively low base compared to most developed country and company debt loads. This has partly to do with the fact that since Asia’s financial crisis in 1997 corporations have been involved in a very significant deleveraging cycle. For instance, since that time, Asia-region corporate leverage (as measured by debt/EBITDA) has come down from 4.6x to about 2x currently, and at the same time cash levels as a percentage of debt have risen from about 20 per cent to near 60 per cent. Corporations in Asia appeared to learn early on lessons US firms would learn a decade later, namely that in the wake of financial crisis uncertainty a firm may need to maintain higher levels of cash and lower amounts of leverage to insure itself somewhat from left-tail economic risks.
Of course, typically speaking, maintaining high corporate cash balances presents a drag to return on equity, but that has generally not occurred with the corporate sector in Asia, partly due to the decline in total interest costs (from near 8 per cent to 9 per cent in 1998, to a bit over 3 per cent today) and improved operating margins. Still, both the low relative leverage of the corporate sector in Asia, and the broad-based debt dynamics presented above, do point to the possibility that the deleveraging cycle for the region may be over.
Figure 2: Asia FI Supply
Finally, we think it is important to emphasise that there are broader social and demographic reasons that would argue for deeper and more robust debt markets in Asia. Demographic workforce trends in the region and modestly aging populations present a natural demand base for yielding assets. This development is partly the result of evolving social safety net programmes, and is particularly important since relying on short duration debt and deposits to fund long duration liabilities and projects can only work for as long as the deposit base grows faster than investment spending, which may not be the case going forward. Developing deeper and more robust debt markets can allow for lower-risk debt rollover and can aid in avoiding asset/liability mismatches over time. As this debt market evolves, it should present opportunities for investors well beyond the region, even as it serves a key functional role within the region.
