"Prolonged COVID-19, High-Risk Asset Losses → Potential Financial Crisis"

Attention to Mezzanine Bonds, High-Risk Bonds, and Leveraged Loans
Sharp Increase in High-Risk, High-Return Product Investments Since Financial Crisis... Close Monitoring Needed

[Asia Economy Reporter Eunbyeol Kim] As the novel coronavirus infection (COVID-19) continues to persist globally, warnings are mounting that instability in the global financial markets could intensify again. While the real economy was initially hit by the outbreak of COVID-19, the pandemic has now shaken financial markets, and high-risk, high-return investment instruments are showing signs of instability, which could negatively impact the financial markets as well.

According to a report titled "Global Financial Risks - Focusing on High-Risk, High-Return Investments" released on the 2nd by Hyuntae Kim, a research fellow at the International Finance Research Division of the Korea Institute of Finance, since the 2008 financial crisis, the prolonged low-interest-rate environment has led to a rapid expansion of high-risk, high-return investments centered on non-bank financial institutions (such as securities firms). Mezzanine debt, high-yield bonds, and leveraged loans are representative examples of high-risk, high-return investments.

Mezzanine debt refers to subordinated debt between senior bonds and common stock in a company's capital structure, including convertible bonds (CB), exchangeable bonds, bonds with warrants (BW), and preferred stock. It is a means for small and medium-sized enterprises to raise funds while minimizing dilution of existing shareholders' equity value. Currently, the size of mezzanine fund assets under management is estimated at about $360 billion, with actual investments around $250 billion. He stated, "Recently, the upward trend in the U.S. commercial real estate market has slowed, and if COVID-19 significantly reduces corporate profits, commercial real estate could stagnate, ultimately increasing losses for real estate mezzanine investors."

As borrowing by low-credit companies increases, the outstanding balance of high-yield bonds (speculative grade below BBB-) has also been on the rise since the financial crisis. The size of BBB-rated bonds among global corporate bond issuance amounts to $7 trillion, accounting for 46% of all investment-grade corporate bonds. If the market deteriorates due to COVID-19, BBB-rated bonds could be downgraded to speculative-grade debt. Particularly, recent increases in high-yield bond investments by insurers and asset management companies have heightened risks. Research fellow Kim said, "The default rate on high-yield bonds usually stays around the low 3% range but can approach double digits during economic recessions."

Leveraged loans, which maintained a high growth rate of over 10% annually with a size between $1.4 trillion and $3.6 trillion as of the end of 2018, also pose a problem. The outstanding balance of leveraged loans in 2019 doubled compared to 2008. Notably, the reduction in subordinated debt, which absorbs shocks before leveraged loans in the event of default, in corporate capital structures over recent years is also pointed out as a risk factor.

Research fellow Kim stated, "It is true that high-risk, high-return investments centered on non-bank financial companies have somewhat excessively progressed since the global financial crisis," adding, "If instability in the global financial markets intensifies, domestic institutional investors could incur losses, or foreign investment funds could be withdrawn, potentially adversely affecting the domestic financial market and real economy."

He also emphasized, "Financial authorities should identify the exposure of domestic financial companies to overseas high-risk, high-return products and encourage gradual portfolio changes to mitigate excessive risk burdens for each financial company."

This content was produced with the assistance of AI translation services.