The appetite for extremely risky assets has grown and grown since the financial crisis of 2008. More debt and margin. It seems like noone is thinking about risk – just reward.
Every since the first debt was issued, there have been individual and institutions that we all know shouldn’t be lent money under any circumstances. If you had a friend who came to you every month and asked for £500 to pay his rent would you help him? Maybe the first time – after all, he’s your friend. Maybe he fell on tough times and just needs a little something to tide him over.
What if he came back the next month and asked for the same thing? Sure, maybe you’d lend him another £500 – after all, perhaps it’s taking him longer than expected to find another job. What if he came again in the third month? And the fourth? What if he was still asking after a year – or two? Would you begin to feel like he was taking advantage of you? Would you feel as confident as you originally did that he’d be able to pay you back? Of course you wouldn’t. You’d call him a bum and tell him to pull himself together. If you’d lent him £500 every month for two years, he’d have £12,000 of your money. A little excessive no? This layabout would need to stop scrounging off you.
The layabout institution
Corporate and government debts are little different. Some institutions have a poor reputation for borrowing money they can ill afford to repay. Maybe they’ve got poor quality balance sheets – perhaps they have little income – perhaps they borrowed money before and failed to repay it.
Investors demand more interest for taking on the risk of lending to these institutions. That higher interest has become increasingly attractive to investors trying to generate a return on their capital. As global yields on assets have collapsed, more and more investors are looking around the market in an attempt to uncover higher returns, seeking profits that have become to generate.
This has lead them to take on more risk and as with every other financial excess since the dawn of mankind this is eventually going to lead to an enormous problem for the economic system. Sure, you might be getting 6% on capital, but do you really want to lend money to the Argentinian government? Call me crazy, but I’d suggest that lending to a country that has defaulted on its debts eight times since 1816 probably isn’t as safe as you think it is…
You look around at some of the other investments on the market and sure, as long as everything stays OK, I’m sure they’ll keep paying out their dividends and growing their revenues…until they don’t.
Are you taking on too much risk?
Maybe taking that level is risk is OK for you but please, please be aware of what you’re investing in. It depends on your portfolio, your balance sheet, your outgoings – don’t just blindly sleepwalk into loading up on poor quality assets that will have high levels of defaults, collapsing prices and potential bankruptcies during the next financial crisis.
Most people don’t understand risk.
Just take a look at bond ratings, which I wrote about in a previous article. When you’re investing in a AAA-rated bond, you’re investing in an institution with an exceptional likelihood of repayment. An institution with a strong balance sheet, stable or growing revenues, low levels of total debt, a strong history of repayment and the general confidence of the markets.
By the time you get down to C-grade bonds you’re basically lending money to your mate. These are the serial borrowers with limited earnings and little ability to repay. In other words, lending to them is placing a significant risk of default on your balance sheet.
By the time you get down to C-grade bonds you’re basically lending money to your mate. These are the serial borrowers with limited earnings and little ability to repay. In other words, lending to them is placing a significant risk of default on your balance sheet.
Investors that are piling into these assets are creating a serious problem for their portfolios that I’m not sure they’re really wise enough to understand. They’re chasing yield and chasing assets which they think will give them some profit. There is too much momentum in the junk markets and uninformed investors are chasing it. Do people not remember what literally just happened in the markets in November and December? The number of people panicking as markets fell was unbelievable – now they’re back buying junk bonds?
Madness.