By Ben Bennett, Credit Strategist at Legal & General Investment Management
As US quantitative easing draws to a close, there is increasing nervousness that the bond market bubble may be about to burst. But the market’s high prices and low yields are not just a problem for bonds, they are a symptom of broader problems created by central bank policy.
During Federal Reserve Chair Yellen’s testimony to the US Congress in July, she voiced concerns about high yield bonds in relation to financial market stability. She didn’t use the phrase ‘bond market bubble’, but she might as well have done given the subsequent rush for the exit by investors in US high yield bond funds. Indeed, US high yield mutual fund outflows during the first week of August were the largest on record, and this is an asset class that benefitted from steady inflows before Yellen’s cautionary remarks.
Are her comments valid? In terms of risk premium, Yellen doesn’t really have a leg to stand on. The excess yield offered by high yield bonds over and above government bond yields has been grinding lower for some time, but remains higher than pre-financial crisis levels when excess yields stayed lower for extended periods of time. And it wasn’t specifically the high yield market that caused the 2009 crisis in any case – it was the rapid unwinding of leverage across broader assets that led to the near-collapse of the US banking system.
Yellen did highlight trends in leveraged lending and underwriting standards as areas to keep an eye on, but again, this does not appear overly concerning from a historical perspective, particularly with default rates near historically low levels. If anything, I’m surprised that more leverage isn’t finding its way into structures given how vocal central banks have been about loose monetary policy.
Indeed, for me, this is where the true vulnerability lies. As Figure 1 highlights, high yield bonds do not look stretched in terms of excess yield, but they do look expensive in terms of total yield. This is all down to exceptionally low government bond yields, driven by years of near-zero interest rates from central banks that are very reluctant to raise rates. Higher rates could lead to more defaults, but this is a natural process of selecting viable businesses and investments, injecting dynamism into the economy and eventually stimulating growth. By keeping interest rates so low for so long, unviable businesses, uneconomic investments and insolvent banks have been allowed to survive and have weighed down investment and potential growth.
While some inefficient high yield companies may have survived thanks to ultra-low interest rates, there are many better examples of distorted asset classes. With government debt soaring globally, perhaps this asset class is vulnerable, particularly when the funding of rising emerging market debt derives from low US interest rates.
The surge in UK house prices also seems to be a concern, especially as prices failed to correct during the financial crisis (again, thanks to the Bank of England slashing interest rates). And then we have the European banking system, where institutions have been able to sit on questionable loans thanks to low interest rates and easy central bank funding. The occasional bank collapse demonstrates that the system is far from healthy, and a lack of lending across the Continent suggests that European banks are in no fit state to serve their purpose.
Central banks may now be facing up to the problems they have created, with the US Federal Reserve likely to end quantitative easing in October, and the Bank of England likely to hike interest rates later this year or early next. (The European Central Bank is unlikely to raise rates any time soon, but growth and inflation is already desperately low, despite negative deposit rates.)
As Yellen’s comments show, central bankers are understandably nervous about the switch from almost limitless monetary policy support to tightening conditions, and are hoping that targeted verbal warnings should help the economy’s preparation. Imbalances and dislocations have been allowed to fester for so long that the occasional warning about high yield lending standards may cause an unwarranted mini stampede and an attractive entry point for tactical investors, but it does little to address the economy’s true problems.
I suspect that central banks will not be able to raise interest rates very much before cracks start to show in economic growth. Their natural reaction will be to cut rates once again and hope for better luck next time. But without a painful clearout of bad investments and a true default cycle, global economic growth will remain disappointing and vulnerable.