Dudley Sees Froth, IMF Sees Froth, Bond Investors Don’t

What’s an investor to do when everyone from the U.S. Federal Reserve to the International Monetary Fund say they see bubbles developing in markets? The answer, apparently, is to keep buying.

In a global economy that looks increasingly perilous, many central banks are showing a greater appetite to step up stimulus measures that have benefited riskier assets since the financial crisis -- the same assets that may lose the most should benchmark interest rates in the U.S. sharply rise.

Analysts at Wall Street firms from Bank of America Corp. to Morgan Stanley say they see opportunities in speculative-grade debt as investors gain confidence that yields will stay low for longer.

“We believe the loan market could prove a bright spot within the leveraged finance world in 2015,” Bank of America analysts led by Michael Contopoulos wrote in a report on high-yield debt dated Oct. 7. “We continue to believe that yields and spreads are likely to end the year lower than current levels, and further recommend adding risk at current levels.”

Fed Bank of New York President William Dudley said yesterday the leveraged-loan market was “a bit frothy.” The remarks came a few hours after the IMF said stocks may be reaching “frothy” levels while cutting its outlook for global growth next year. Germany’s industrial production fell in August more than economists forecast, the latest sign of deterioration in Europe’s largest economy.

Bank Warnings

The concern that economic growth will slow and continue to suppress inflation is sparking renewed demand for bonds and fixed-income assets even with yields at about record lows and underwriting standards in credit markets slipping. Junk bonds in the U.S. have returned 0.67 percent this month, after losing 2.1 percent in September, Bank of America Merrill Lynch indexes show.

Dudley said the Fed is continuing to monitor the market for high-risk leveraged loans after warning banks last year on credit standards. “We are following up with those banks to see how closely they are following the guidance,” Dudley said yesterday in a speech in Troy, New York. “We think the market is a bit frothy.”

Going Long

Investors are even more enthusiastic about long-dated Treasuries, which have returned 19 percent this year, including reinvested interest, Bank of America Merrill Lynch index data show. That compares with a 6.3 percent gain in the Standard & Poor’s 500 Index. Notes maturing in 15 years or more have gained 2.7 percent this month alone, as 30-year Treasury yields fell to 3.05 percent yesterday, the lowest since May 2013.

“The one market seemingly everyone ‘knows’ is a bubble is the Treasury market,” Brean Capital LLC’s Peter Tchir wrote in a note today, adding that he sees greater risk in high-yield bonds and stocks.

Economists are slowly capitulating on their calls for higher yields, with a Bloomberg survey showing that the consensus now is for benchmark 10-year Treasury yields to rise to 2.74 percent by year-end, from 2.36 percent currently. At the start of the year, they forecast a yield of 3.44 percent.

The demand for both long-term and riskier debt shows just how dismissive investors are of the prospect of rising rates, as well as potential bond bubbles that may be brewing. Warning about market froth is one thing. Finding alternatives to frothy markets is another.