Goldman Sachs’s Cohn Says Bonds Pose Big Risk After Record Rally
Debt markets that have seen junk- bond yields drop to record lows may face a ‘‘substantial repricing’’ if interest rates spike or investors begin pulling money out of fixed-income, Goldman Sachs Group Inc. (GS) President Gary Cohn said.
A sudden or large increase in rates would be a shock to markets, presenting ‘‘a big risk’’ with ‘‘a low probability,’’ Cohn, 52, said in an interview today with Bloomberg Television’s Erik Schatzker at the World Economic Forum in Davos, Switzerland. Such a move would potentially be heightened by a liquidity shortage as large banks cut holdings to comply with new capital requirements, he said.
‘‘I’m concerned when money starts flowing out of fixed- income funds, with firms trying to reduce their risk-weighted assets and firms trying to reduce their balance sheets, who will be the ultimate buyer of those fixed-income products?” Cohn said. “Someone has to buy them, and maybe it takes a fairly substantial repricing of fixed income to find the next round of buyers.”
Investors have funneled cash into junk bonds at a record pace as the Federal Reserve holds benchmark interest rates between zero and 0.25 percent and buys back bonds to suppress borrowing costs. Bond sales by Spain and Portugal this week are among signs that the European sovereign-debt crisis has eased. Buyers of fixed-income products must be told that “just because it is a bond doesn’t mean that it trades at par,” Cohn said.
The 13 largest investment banks have announced plans to cut $1.03 trillion in risk-weighted assets, consulting firm McKinsey & Co. said in a report yesterday. Inventory holdings of corporate bonds by top dealers have dropped about 40 percent from two years ago and are less than a quarter of their 2007 peak, according to data compiled by Bloomberg.
“A lot of the banks have a new plan of de-risking their balance sheets, getting their risk-weighted assets down to try to improve their equity ratios,” Cohn said. “And I’m not sure that that capital can come back into the market quick enough” if there’s a sell-off, he said.
Cohn is not the first to warn of a potential liquidity squeeze for institutional investors that have driven junk bond yields to record lows. Greenwich Associates, a consulting firm that surveys large investors, said in a report this month that banks have increasingly relied on electronic trade crossing, a process that depends on a large number of buyers.
“When everyone wants to sell, there will be no one on the other side to cross trades with and capital-constrained banks will have no interest in assuming their traditional role of liquidity backstops,” Andrew Awad, a Greenwich consultant, said in the report.
Yields on dollar-denominated junk bonds dropped to an unprecedented 6.46 percent on Jan. 22, and prices rose to 105.6 cents from as low as 54.8 cents in December 2008, according to Bank of America Merrill Lynch index data.
Yields over benchmarks for junk debt owned by exchange- traded funds are 2.03 percentage points less than for below- investment-grade bonds that they don’t hold, the widest gap on record, according to Bank of America Corp. The difference between yields on offerings above and below $400 million has widened to about the highest level since February 2009, as investors favor bonds sold in the most liquid batches.
Portugal sold 2.5 billion euros ($3.34 billion) of five- year bonds through banks, the first offering of that maturity in almost two years. Spain sold 7 billion euros of 10-year bonds on Jan. 22, a sale Economy Minister Luis de Guindos said had the biggest demand in the nation’s history.
“At some point, interest rates will go higher again, and all of the money that has piled into fixed income over the past three years, some of it will come out,” Cohn said. “We will clearly be there to facilitate, we will clearly be there to provide balance sheet and liquidity to our clients, but ultimately, we can’t be the buyer of last resort.”
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