The stage is set for another financial crisis to unravel years of relative calm in debt markets.
At least that’s how firms from UBS Group AG to Invesco Ltd. see it. Here’s why: Prices in the world’s biggest bond market are swinging and the plunge in oil is sinking the economies of nations from Venezuela to Nigeria.
To top all that off, the fundamental structure of the bond market has changed in a way that makes it difficult for regulators to gauge exactly where risks are building.
As stresses grow, “we believe the probability of an ‘accident’ increases,” Invesco analysts including Rob Waldner wrote in the $786.5 billion manager’s February fixed-income outlook. “The overall environment for risky assets, and particularly for credit, is deteriorating.”
Oil, which has plunged to below $50 per barrel from $107 in June, may cause more energy companies to default on their billions of dollars of debt than many investors are expecting, according to UBS analysts.
Then there’s government bonds.
While the Federal Reserve considers raising overnight borrowing costs from about zero, where they’ve been since 2008, central banks in Europe are dropping deposit rates into negative territory.
This backdrop has pushed a measure of expected Treasury price swings to levels that are about 40 percent higher this year than in the same period in 2014, according to Bank of America Merrill Lynch’s Option Volatility Estimate MOVE index.
“The risk in bonds has gone up,” Francesco Garzarelli, London-based co-head of macro and markets research at Goldman Sachs Group Inc., said in a Bloomberg Television interview Thursday. “The sensitivity to small changes in yield expectations from here will command very sizable price swings, and I just think that makes fixed income a very dangerous asset class.”
That all sounds pretty bad already. And in fairness, it may be premature or just wrong, with yields staying stable and low for longer than most analysts are predicting.
But there’s more that’s adding to the concern.
UBS analysts are also nervous about the changing composition of who owns the trillions of dollars of debt that’s been sold in the past six years.
While the biggest banks have cut back on their positions in risky, speculative-grade debt, it’s steadily migrated to large institutions, insurance companies and mutual funds. Such firms have boosted their holdings of corporate and foreign bonds to $5.1 trillion, a 65 percent increase since the end of 2008, according to data compiled by UBS.
This has more than offset the $800 billion decline in holdings at banks and securities firms in the period, a regulator-prompted retrenchment that was intended to reinforce the financial system, UBS analysts Matthew Mish and Stephen Caprio wrote in a Feb. 26 report.
What we’re left with instead -- ballooning bond funds that own more and more risky debt -- may be a less bad option, but one that still threatens to wreak havoc in credit markets.
“Our understanding of the institutional asset management industry is rather nascent,” the UBS analysts wrote. “The contribution of institutional investors to financial stability is positive in good times, but their impact is less certain in bad times – particularly very bad times.”