The good news for bullish debt investors is that riskier assets will probably keep rallying in the near term.
The bad news is that the longer the rally continues, the more these investors stand to lose of their principal investments down the line.
That's because companies and consumers have substantially boosted their leverage in the past few years as central bankers worldwide flood the market with cash to suppress borrowing costs. This implies lower recoveries in the future, according to Matthew Mish, an executive director in global credit strategy at UBS AG. In other words, companies and consumers that eventually become insolvent will have fewer assets available to repay their growing mountain of obligations.
This is already happening on a small scale in the U.S. auto industry, which has been suffering recently from falling sales and lower used-car values. Consumers borrowed more money than they could repay to buy new cars and trucks and are now defaulting on those loans at an increasing pace. Ultimate recoveries have declined to levels not seen since 2009, amid the worst financial crisis since the Great Depression.
U.S. companies haven't truly been tested yet on a broad-based level with the exception of energy and retail corporations, which have faced some issues unique to their sectors. American companies have generally added debt at a record pace, leading to historically high leverage ratios. This leaves senior debt investors with a historically low cushion protecting them from losses in a default, as Mish pointed out on Thursday in a report that was co-written by Stephen Caprio of UBS.