The prevalence of negative interest rates and the rise of collateralized loan obligations (CLOs) are highlighted as key concerns by the Bank for International Settlements (BIS) in its latest quarterly review.
The BIS reported that, in late August, more than US$17 trillion worth of bonds were trading at negative rates, and some households were borrowing at negative rates.
“A growing number of investors are paying for the privilege of parting with their money,” said Claudio Borio, head of the monetary and economic department of the BIS. “Even at the height of the great financial crisis of 2007-2009, this would have been unthinkable.”
“There is something vaguely troubling when the unthinkable becomes routine,” he added.
Additionally, Borio noted that the credit position of non-financial corporations in general “and the surge in leveraged loans in particular, represent a clear vulnerability.”
Increasingly, these loans are also being used in CLOs, which recalls the “infamous collateralised debt obligations (CDOs), which resecuritised largely subprime mortgage-backed securities and played a central role during the [financial crisis],” Borio noted.
The BIS review found that the growing CLO sector is not as big a worry as CDOs were in the run up to the financial crisis, but Borio said that “financial distress cannot be entirely ruled out, especially in the light of the concentration of some known bank exposures, uncertainties about the size and distribution of indirect ones, and the surge in market finance post-crisis.”
Additionally, some fixed-income investment funds are investing in CLOs, which represents a potential vulnerability too.
“At times of market distress, investors may rush to redeem their shares, quickly depleting the liquidity buffers held by such funds,” the review said. “This rush could result in fire sales and large price volatility, imposing mark-to-market losses on other intermediaries.”
“Losses on these asset classes, and leveraged loans more generally, are likely to amplify any economic slowdown,” Borio noted.
With interest rates already low, and trending lower, the BIS said that government spending would likely be needed to combat future economic weakness.
“Should a downturn materialize, monetary policy will need a helping hand, not least from a wise use of fiscal policy in those countries where there is still room for manoeuvre,” Borio said.