Yellen Sees Risk of Bubbles in Leveraged Loan Market

Federal Reserve Chair Janet Yellen warned she sees signs of asset price bubbles forming in some markets such as those for leveraged loans and lower-rated corporate debt, while indicating stocks aren’t overvalued.

“We’re seeing a deterioration in lending standards, and we are attentive to risks that can develop in this environment” of low interest rates, Yellen said today in semi-annual testimony to the Senate Banking Committee.

With stocks hovering near record highs, Yellen signaled she isn’t worried about frothy markets broadly, saying in prepared remarks that equities, real estate and corporate bond values are in line with historical norms. The Fed needs to hold its benchmark policy rate near zero, where it’s been since December 2008, until the labor market improves and inflation accelerates, she reiterated.

In a report accompanying Yellen’s testimony, the Fed also raised concerns over “equity valuations of smaller firms as well as social media and biotechnology firms,” though it said broader equity markets don’t signal too much investor optimism.

The Standard & Poor’s 500 Index fell 0.2 percent at 3:15 p.m. in New York. The Russell 2000 Index of small companies sank 0.9 percent.

Responding to questions from the committee, Yellen said low interest rates can be conducive to the formation of bubbles, and that the Fed was watching carefully for signs of such increased risk-taking. She cautioned that the central bank will not “be able to catch every asset bubble.”

Risky Lending

A boom in the market for junk-rated loans has drawn the attention of the Fed and the Office of the Comptroller of the Currency, which have urged banks since last year to curb risky lending.

While issuance has been robust, “underwriting standards have loosened,” according to the Monetary Policy Report, presented with the Fed chair’s congressional testimony twice a year. The central bank is working with other federal regulators to “enhance compliance with previous guidance on issuance, pricing and underwriting standards,” according to the report.

In equity markets, the Fed saw signs of increased risk-taking limited to small-cap stocks and biotech and social media shares.

“Valuation measures for the overall market in early July were generally at levels not far above their historical averages, suggesting that, in aggregate, investors are not excessively optimistic regarding equities,” according to the report.

Biotech Sell-Off

The iShares Nasdaq Biotechnology ETF fell as much as 2.8 percent after the release of the report. The Global X Social Media Index ETF fell as much as 2.1 percent.

The warning on biotech and social media shares contained in the report, however, may be more a reflection of the views of Fed staff than of Yellen and her colleagues on the Federal Open Market Committee, said Roberto Perli, a partner at Cornerstone Macro LP in Washington and a former Fed economist.

“We don’t have much evidence” that the comments on biotech and social media reflect Yellen’s opinion, Perli said.

“Usually what happens is the Board’s staff writes the Monetary Policy Report, and then there is a Board meeting to go through the whole report, but usually the meeting focuses on the policy part,” Perli said. Yellen could have addressed these concerns directly in her testimony if she felt strongly about them, he said.

Federal Reserve Bank of New York President William C. Dudley said on March 6 that while he didn’t “really see much excess in terms of things that worry me about financial stability,” there were some areas that may be overvalued, including biotech stocks, leveraged loans and farmland.