Bond investors responded to Federal Reserve Chair Janet Yellen’s warnings this week of debt-market complacency by taking on more risk.
A day after Yellen cited “evidence of reach-for-yield behavior” in comments to reporters, credit derivatives traders accepted the lowest premiums in almost seven years to protect against corporate defaults. Junk-bond buyers pushed yields to a new record low. And a group of banks started laying the groundwork for what would be the second-biggest offering ever of speculative-grade securities by a company.
Investors signaled that what they actually heard during the Fed chair’s June 18 comments was her brushing aside concern that inflation was accelerating and emphasizing that the central bank will likely keep borrowing costs low “for a considerable time.” A sixth year of short-term interest rates near zero have pushed investors into the riskiest corners of debt markets to boost yields that continue to evaporate.
“The reach for yields is going to get worse,” William Larkin, a money manager who oversees $520 million at Cabot Money Management, said in a telephone interview. “She had all these opportunities to at least put the runway down and lower the landing gear and at least talk about raising short term rates. But she didn’t take that route.”
Investors are scouring credit markets for higher returns as central banks around the world suppress interest rates to spur economic growth. Yields on company bonds from the U.S. to Asia have dropped 5.47 percentage points since the height of the financial crisis in 2009 to 3.26 percent, approaching a record low reached last year.
“This low-interest-rate environment, as much as it’s appropriate at this point in time, over a medium and longer period of time is kind of worrisome, especially in a German environment,” Bundesbank board member Andreas Dombret said in a Bloomberg Television interview with Haslinda Amin in Singapore yesterday. “We’ve seen in other countries this has led to housing bubbles so this is something we have to watch closely.”
The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark used to hedge against losses or to speculate on creditworthiness, has dropped 3.6 basis points since June 17 to 56.6 basis points, and yesterday reached the lowest level since October 2007, according to prices compiled by Bloomberg. The measure, which typically falls as investor confidence improves and declines as it deteriorates, has fallen by more than half during the past two years.
The extra yield investors demand to own debt of the riskiest corporate borrowers instead of government securities narrowed to 339 basis points, or 3.39 percentage points, yesterday, also the lowest since 2007 and 252 basis points below the 10-year average in the Bank of America Merrill Lynch U.S. High Yield Index. Yields on the debt fell to an unprecedented 5.71 percent.
Valeant Pharmaceuticals International Inc. said June 18 that it will seek to tap into that demand for risky assets with a proposed $12 billion of junk-rated debt to fund its attempted hostile takeover of Allergan Inc. It would be the biggest on record after billionaire Patrick Drahi’s $17 billion sale in April.
Valeant, which has teamed with Pershing Square Capital Management LP’s Bill Ackman, said in a filing that it had received commitments from banks to finance its bid.
The hunt for yield is spanning across debt classes. In the market where auto loans to people with spotty credit are bundled into bonds, the difference in yield between the lowest-rated securities and the safest has narrowed to the least since August 2007, according to Wells Fargo & Co. data. Investors have piled into the debt even as default rates on the loans reach an “inflection point” with borrowers falling behind and loan terms easing, S&P analyst Amy Martin said in an interview in March.
Bond buyers also are accepting the lowest relative yields in almost a decade to own debt linked to insurance against hurricanes and other natural disasters. Buyers are speculating that the $22 billion market can continue its streak without an annual loss even as Warren Buffett said last week that Berkshire Hathaway Inc. is avoiding writing hurricane insurance in Florida because premiums have been pushed too low.
‘Sense of Complacency’
“People are lulled into a sense of complacency,” said Bonnie Baha, director of global developed credit at Los Angeles-based DoubleLine Capital LP, which manages about $50 billion. “The market has a very short memory. At some point, the music has to stop.”
The central bank has kept its benchmark lending rate between zero and 0.25 percent since the end of 2008. And while the Federal Open Market Committee continued scaling back asset purchases that have helped suppress borrowing costs, staying on pace to end them late this year, Yellen reiterated that the Fed expects interest rates to stay low long after the buying ends.
The Fed meeting followed actions two weeks ago by European Central Bank policy makers that included cutting their deposit rate to minus 0.1 percent and lowering the key interest rate to a record 0.15 percent.
“It is apparent that rates aren’t going to break out for a while and investors still have money to put to work,” Rob Smalley, head of the credit desk analyst group at UBS AG in New York, said in a telephone interview. “Fixed income investors might see this year as a gift that they won’t get again.”
While investors rejoiced, Yellen cautioned that the central bank is monitoring threats to financial stability, including “trends in leveraged lending and the underwriting standards there, diminished risk spreads in lower-grade corporate bonds. High-yield bonds have certainly caught our attention.”
Investors are focusing on the central bank’s lowered expectation of its long-run estimated target interest rate to 3.75 percent from 4 percent, reflecting slower long-term growth for the U.S. economy, according to LPL Financial Holdings Inc.’s Anthony Valeri.
“When the Fed talks about leaving rates lower for longer, investors have no option but to accept the new reality,” Arthur Tetyevsky, a credit-trading strategist at Imperial Capital LLC in New York, said in a telephone interview.