Desperately seeking yield
The striking appeal of corporate bonds
Mar 9th 2013
EMERGING markets, technology stocks, American (and Irish) houses and the mortgage-linked debt that was associated with them: the history of the past 30 years has been marked by a series of asset-price bubbles, often fuelled by cheap money. Investors have put their cash to work in search of the next “sure thing”.
Several years of historically low interest rates in the rich world have caused many to speculate on where the next bubble might occur. One possibility is the corporate-bond market, where yields have fallen remorselessly (see chart).
The dangers are twofold. The first is that investors are not allowing for a sufficiently high margin, or spread, over government-bond yields to compensate for the higher risk that companies may default. The second is that bond yields could rise (and prices fall) if either the economy returns to robust growth or inflation rises sharply, prompting central banks to increase interest rates. One of the nastiest years for bond investors in history was 1994, when the Federal Reserve started to tighten monetary policy.
PIMCO’s Bill Gross, probably the best known bond manager in the world, said in his latest outlook that: “Corporate credit and high-yield bonds are somewhat exuberantly and irrationally priced. Spreads are tight, corporate profit margins are at record peaks with room to fall, and the economy is still fragile.”
Spreads are not yet at the lows they reached in 2007 when the credit bubble was at its height. But in a speech last month Jeremy Stein, a Fed governor, pointed to a number of signs of frothy markets. In the fourth quarter of last year, for instance, two forms of risky debt issuance—payment-in-kind (PiK) bonds and “covenant-lite” loans—reached volumes last seen in 2007. The former are bonds where interest payments are made in the form of more bonds, rather than cash; the latter are loans with fewer safeguards for creditors if the borrower’s financial condition deteriorates. An increased appetite for such securities suggests that investors are willing to take more risk.
Matt King, a strategist at Citigroup, points to further warning signs. Spreads normally rise when companies take on more debt. This time European corporate leverage has risen but spreads have fallen. In addition, broker-dealers have very low bond inventories, a result of reduced risk-taking and tougher regulation since the financial crisis. If bond investors were to turn from buyers to sellers, prices could fall sharply in an illiquid market.
Given these worries, what explains the continued enthusiasm for corporate debt? It is not just that low interest rates have made investors seek out alternatives to cash; they have also made it easier for firms to service debts. Data from Standard & Poor’s, a rating agency, show that the default rate for speculative-grade American bonds in the 12 months to February was 2.3%, well below the historic average.
Furthermore, central-bank purchases of bonds have reduced the supply of debt available for investors to buy. Net issuance of new securities (deducting central-bank purchases) has fallen from $3.7 trillion in 2009 to $918 billion on a rolling 12-month basis, says Citigroup.
This reduced supply has been met by voracious demand. According to Morningstar, a research firm, the average monthly inflow into American bond mutual funds over the past three years has been $18.5 billion; US equity funds have seen average outflows of $7.2 billion. In January, despite much talk of a “great rotation” out of bonds and into equities, bond funds received inflows of $38.1 billion and equity funds (domestic and international) had inflows of $37.8 billion.
There are a few signs that investors are demanding higher yields from corporate issuers in 2013 but nothing that indicates panic. As long as the return on cash is so low, it is unlikely that bond funds will see massive outflows. To the extent that investors are moving into equities, they are probably shifting out of cash and money-market funds, not bonds.
So for a collapse in the corporate-bond market to happen there will either have to be a sudden reversal of central-bank policy or a wave of defaults. The former looks highly unlikely this year. The latter is most likely to occur if companies suddenly go on a wild spending spree with borrowed money. A recent pickup in mergers and acquisitions may eventually lead to the kind of excesses that have been seen in the past. But these are early days. If this is a bubble, it probably has a bit more inflating to do.