Bond Hubris Overwhelms Fed in Riskiest Credit-Market Sectors
Bond investors trying to divine when the Federal Reserve will reduce its unprecedented monetary stimulus are increasingly looking to the riskiest parts of the debt market, which are booming like before the financial crisis.
The amount of loans made this year that lack standard protections for lenders exceed the all-time high set in 2007, and only one other time have investors pumped more money into funds that buy lower-rated loans than they did last week. Bonds rated in the lowest category of junk accounted for the greatest percentage of speculative-grade offerings last month since 2011.
While Fed policy makers say employment and inflation will be the primary determinants of when and by how much they reduce the $85 billion a month being pushed into the economy every month through bond purchases, signs of excessive risk-taking are likely to also play a part. Chairman Ben S. Bernanke and Fed Governor Jeremy Stein have cited the potential for continued so-called quantitative easing, or QE, to disrupt financial markets.
When to reduce “seems to be a risk-management issue as opposed to a pure economic issue because the Fed hasn’t really met its mandates with respect to employment gains or with inflation,” Christopher Sullivan, who oversees $2.2 billion as chief investment officer at United Nations Federal Credit Union in New York, said in an Aug. 7 telephone interview.
Bernanke is aware of the risks to the economy, after leading the Fed through the worst financial crisis since the Great Depression, when financial firms posted credit losses of more than $2 trillion as the subprime-mortgage market collapsed, the Standard & Poor’s 500 Index of stocks fell by more than 50 percent and home foreclosures rose to a record.
“Having experienced the damage that asset-price bubbles can cause, we must be especially vigilant in ensuring that the recent experiences are not repeated,” Bernanke warned in a 2010 speech. “We must remain open to using monetary policy as a supplementary tool for addressing those risks.”
Fed policy makers next meet to decide monetary policy on Sept. 18. That’s when they will likely trim their monthly bond purchases to $65 billion, according to half the 54 economists surveyed by Bloomberg from July 18 to 22.
Concern that the Fed may reduce its stimulus sent bond markets plunging, pushing borrowing costs higher.
Yields (USGG10YR) on 10-year Treasury notes, a benchmark for everything from corporate bonds to mortgages, rose to 2.74 percent July 5, the highest since August 2011, from 1.93 percent May 21. That was the day before Bernanke said policy makers “could take a step down in our pace of purchases.”
Markets have since calmed. Treasury 10-year yields were little changed at 2.58 percent as of 8:35 a.m. in New York from Aug. 9. The price of the benchmark 2.5 percent note due August 2023, which was auctioned Aug. 7, was 99 10/32.
After initially pausing, high-yield credit markets have begun to rally again as investors seek alternatives to the zero rates engineered by the Fed.
Funds that purchase speculative-grade, or leveraged, loans in the U.S. attracted $2 billion last week, the second-biggest inflow on record, according to Charlotte, North Carolina-based Bank of America Corp. Companies will raise as much as $360 billion of the debt this year, Barclays Plc said Aug. 9, up from an earlier estimate of as much as $250 billion.
The market for so-called covenant-light loans that lack typical lender safeguards such as limits on debt has already soared to $155 billion this year, beating the record $96.6 billion in 2007, according to Standard & Poor’s Capital IQ Leveraged Commentary and Data.
Junk-bond sales rose 24 percent to $235.3 billion through Aug. 9 compared to the same period a year ago, according to data compiled by Bloomberg. Those securities and leveraged loans are rated below Baa3 by Moody’s Investors Service and less than BBB-at S&P.
Sales of payment-in-kind, or PIK, notes, which allow borrowers who can’t meet interest obligations to pay with additional debt, total more than $6.5 billion this year, on pace to top the $8.1 billion issued in 2012, Bloomberg data show.
Corporate bonds in the lowest rating tier of CCC made up 10.3 percent of the $22.4 billion in high yield sales in July, the most since 2011, according to JPMorgan Chase & Co.
While the recent activity is raising concern, it doesn’t match the frothiness of 2006 and 2007, when dealers packaged bonds backed by subprime mortgages into ever-riskier securities.
Global issuance of collateralized-debt obligations, or CDOs, backed by corporate loans and high-yield securities surged to a peak of $482 billion in 2006 from $5.7 billion in 1995, according to data compiled by trade magazine Asset-Backed Alert. CDOs are almost nonexistent now.
“The use of financing at that point was for” leveraged buyouts “and ever larger LBOs whose economics were doubtful and were proven to be disastrous,” Krishna Memani, the New York-based chief investment officer for OppenheimerFunds Inc.’s $79.1 billion fixed-income portfolio, said in an Aug. 6 telephone interview. “Issuers in the leveraged-loan market today are in much better financial shape than they were in 2007.”
Corporate default rates, at about 3 percent, are near historic lows, according to Moody’s, generating a sense of complacency among investors.
Memani said he likes “credit in all forms,” including investment-grade and high-yield company debt, emerging-market bonds and structured credit.
Fed Governor Stein said in a February speech that investors in company debt had been engaging in “a fairly significant pattern of reaching-for-yield behavior.”
At 7.4 percent, the jobless rate remains above the Fed’s 6.5 percent target, while the rate of inflation is below 2.5 percent, levels policy makers said would trigger a reduction in its bond purchases.
“Unlimited QE without the risk of any kind of tapering or end in sight perhaps is unnecessary given that risky assets are somewhat elevated and that the downside economic risks that existed at the end of last year, such as Europe and the fiscal cliff, have clearly gone away,” Dominic Konstam, the head of interest-rate strategy at Deutsche Bank AG in New York, said in an Aug. 2 telephone interview.
The firm is one of the 21 primary dealers of government securities that trade with the Fed.
Bonds rated CCC and lower lost 2.4 percent between May 22, when Bernanke said the central bank was considering reducing or ending the asset purchases, and June 19, when he reiterated those comments.
Since then, the debt has gained 3.5 percent as yields fell to an average of 9.79 percent on Aug. 7 from a seven-month high of 10.6 percent on June 25, Bank of America Merrill Lynch bond indexes show.
Most risk assets “have probably retraced a good 75 percent on average of the widening that occurred in the late May and June period,” Michael Materasso, co-chairman of the fixed-income policy committee at Franklin Templeton Investments in New York, said in an Aug. 5 telephone interview.
The firm, which oversees $365.7 billion of bonds, has been buying higher-rated company debt, municipal bonds and securitized credit, Materasso said.
With slow global economic growth, people are “looking for yield and investors are making decisions that they normally wouldn’t,” he said. “They can get burned pretty badly given how low yields are in the absolute sense, as well as in some areas how tight credit spreads are compared to where they could be in a more credit-deteriorating environment.”
Investors convinced the Fed is going to keep interest rates low through 2016 are more willing to take risk and add leverage, forcing the central bank into a balancing act to encourage lending while preventing bubbles, according to Lawrence McDonald, senior director for credit, sales and trading at Newedge USA LLC.
“If you’re too accommodative, the serpent in the market will come back and start speculating really quickly, and that’s what’s happened to some extent,” he said in an Aug. 5 telephone interview. “They’re watching that like a hawk.”
McDonald, the author of the book, “A Colossal Failure of Common Sense,” on the 2008 demise of Lehman Brothers Holdings Inc., is forecasting the Fed will taper in September.