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Investors rush into high-risk assets in easy credit environment

Vast liquidity released by central banks flowing into shadow banking sector

SPAC, Cryptocurrency, and CLO booms rise warning stage all over the world.(Source photo by Reuters)   © Reuters

TOKYO/ NEW YORK -- High-risk assets have recently become the investments of choice as global markets swim in liquidity while interest rates remain at historic lows, spurring worries about another financial crash.

The recent collapse of Archegos Capital Management, a New York investment fund which last month defaulted on highly leveraged margin calls, triggering a massive fire-sale of stocks, shows the risk involved in such trades. Its collapse rippled out to institutions across the world, causing hefty losses.

The new bond issuance by U.S. cruise ship operator Royal Caribbean Cruise on March 29 was another case in point. The deal came at an interest rate that surprised many. Even though S&P Global had downgraded the company's credit rating to B in February, the bonds were set at a coupon of 5.5%, about half the steep yield of 11.7% at which the firm sold bonds in May last year.

Companies around the world are increasingly selling sub-investment grade bonds, or those rated below BBB. During the first three months of this year, a record $208.3 billion of such bonds were issued. The total amount of outstanding junk bonds now tops $2 trillion, according to a market estimate.

Another sign of growing risky borrowing is the rising supply of collateralized loan obligations, a form of financial instrument that pools together streams of loans and repackage them into blocks of securities to be sold to investors.The outstanding amount of CLOs hit $662.3 billion in 2020, a 50% rise in five years.

This growth raises concerns because CLOs are a close cousin of collateralized debt obligations that are essentially a pool of bonds, loans and their derivatives structured into new debt that are onsold. It was the expansion of such instruments that precipitated the 2008 global financial crisis.

In the stock market, SPACs -- or special purpose acquisition companies -- are also proliferating. These listed shell companies exist solely to find private companies to buy and take public. SPACs raised a total of $217.9 billion between 2016 and March this year. That figure reflects a 140% jump in six months.

Some Asian stock markets are keen to get on the bandwagon. The Singapore Exchange plans to allow SPACs to be listed as early as the middle of this year. The Hong Kong and Indonesian markets are considering that move as well, in hopes of attracting promising Asian startups.

In response to "an unprecedented surge in the use and popularity of" SPACS in the U.S. securities markets, a senior official of the U.S. Securities and Exchange Commission issued a statement on April 8 stressing the organization was "continuing to look carefully at filings and disclosures by SPACs and their private targets."

The statement sought to reassure investors: "They (the staff at the SEC) will continue to be vigilant about SPAC and private target disclosure so that the public can make informed investment and voting decisions about these transactions."

An increasing number of SPACs are failing to acquire the targets they had set out to, as the SPAC boom has driven up the costs of buying businesses.

Investors are also piling into cryptocurrencies, which are rapidly gaining in popularity as an alternative investment vehicle. The value of the cryptocurrency market topped $2 trillion for the first time in April, a figure close to the market capitalization of Apple, the most valuable company in the world.

Since the global credit crisis of 2008/2009, banking regulators around the world have tightened laws to toughen up financial systems to prevent another crash. The U.S., for instance, developed the Volcker Rule, which prohibits banks from using customers' money to make their own bets on the markets, under the Dodd-Frank Financial Reform framework, a sweeping regulatory act that subjects financial firms to stricter government oversight.

Yet, there has been a major resurgence in the business of risky loans. The money is bypassing the traditional, and heavily regulated, banking system and flowing through a growing network of businesses that provide financing to high-risk businesses and investments.

A spotlight was shone on the vulnerabilities of the shadow banking sector when Archegos collapsed. Archegos is a family office capital management firm and such entities are private investment vehicles of the extremely wealthy. They are estimated to control some $5.9 trillion in assets. That is more than the total assets of hedge funds, some $3.6 trillion, or venture capital funds at $1.36 trillion.

The successive headline-making blowups of Greensill Capital and Archegos have had some sobering effects on money managers and risk investors across the globe.

In his letter to shareholders dated April 7, Jamie Dimon, chairman and chief executive officer of JPMorgan Chase, sounded the alarm, saying "growth in shadow banking has also partially been made possible because rules and regulations imposed upon banks are not necessarily imposed upon these nonbanks."

More ominously, he said in the letter: "While it is not clear that the rise in nonbanks and shadow banking has reached the point of systemic risk, this trend is accelerating and needs to be assiduously monitored, which we do regularly as part of our own business."

Markets may have become too complacent due to the success of central banks in calming markets and shoring up confidence through monetary expansion programs.

With expectations of a sharp economic rebound growing in the U.S. amid the country's dramatic vaccination program, the Federal Reserve remains positive about continuing its extremely easy money policy, providing a strong incentive for investors to flood into high-risk assets.

If, however, strong economic recovery pushes up long-term interest rates, the whole situation could change quickly, leaving investors with huge exposures to high-risk assets in hot water.

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