Wednesday, August 26, 2015

The High Risk Debt Bubble

With former Federal Reserve Chairman Alan sounding the alarm about a bond-market bubble that has developed as a result of the prolonged period of zero interest rates, investors should be worried.  Thinking back to his 1996 "irrational exuberance" speech, it is quite apparent that he is the master of understatement, particularly given that shares in the tech sector collapsed four years later.  Here is the most-remembered quote from his speech:

"Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy."

To me, the greatest problem with the Fed's zero interest rate policy has been the flight to yield which has escalated the value of one particular asset class to unrealistic values.  With just about everyone from individual investors to the world's largest pension plans desperately searching for a reasonable return on their investments, investors have taken on levels of risk that they would not ordinarily take.  This is particularly evident in what are termed "high yield corporate debt" or, as it is better known on the street, "junk bonds", terms which I will use interchangeably in this posting.

Let's start this posting by looking at the issuance of high yield corporate debt in the United States and then look at the global high yield debt picture.

Here is a graph from FRED showing how the issuance of corporate junk bonds in the United States has grown since 1949:

Here is the same data, focussing on the period since late 2007:

As you can see, junk bond issuance dropped by $631.64 billion or 9.5 percent from Q3 2008 to Q4 2010 but has since risen to its all-time peak of $7.715 trillion in Q1 2015, an increase of $1.701 trillion or 28.3 percent in just over four years.  With interest rates so low, one should hardly be surprised that what would be considered less than creditworthy companies are out there, raising cheap money hand over fist.

Here is a graph showing the annual percentage change in the volume of low-rated corporate debt issued:

We can clearly see how outstanding junk bond debt decreased by up to 6.7 percent on an annual basis just after the Great Recession and how the outstanding junk bond debt has risen by between 5.0 and 7.5 percent since Q4 2011.  As well, the issuance of new junk bond debt is showing no signs of slowing down.

This is what the spread between CCC-rated securities and "no risk" United States Treasuries looks like:

At 11.74 percent, the spread has risen from its low of 6.39 percent in June 2014 but is still well below the levels seen in the early 2000s and during the Great Recession.  The recent rise is suggesting that some risk is already being priced into junk bonds, however, as you can see from the graph, the spread is still well below the peak of 36.7 percent seen in November 2008 and significantly less than the 25 percent last seen in 2001.  This tells us that, should investors suddenly realize that the risk level on corporate junk bonds is far higher than it appeared during the recent long period of near-zero interest rates, the prices of these bonds could drop significantly as the yield rises to better reflect the risk profile.

Now, let's focus on the global market for high yield debt.  In Thomson Reuters' latest Debt Capital Markets Review, current to the end of the first half of 2015, we find this graphic which shows the global quarterly issuance of corporate high yield debt:

The global volume of high yield debt reached $241.6 billion during the first half of 2015, down 12 percent from the first half of 2014.  This is the slowest first half for global high yield debt in two years with Q2 2015 high yield debt issuance dropping by 27 percent from the same quarter in 2014 when a record $160.3 billion worth of junk bonds were issued.  A total of $176.8 billion in high yield debt was issued in the United States and globally, $251.5 billion in high yield debt was issued.  Of the new global high yield debt issued, JP Morgan was responsible for 11.1 percent of the market share, the highest among all banks.  High yield corporate debt totalled 15 percent of the total global debt issued by JP Morgan in the second quarter of 2015 and, for the world's other major players, we can see how important junk bonds (in dark blue) are to their underwriting fees as shown on this graphic:

Here is a table showing the top 10 issuers of US high yield corporate debt during the first half of 2015:

From all of this data, we can clearly see why Alan Greenspan is concerned about a debt/bond market bubble.  High yield/junk bonds are in a no-win situation, when interest rates begin to rise, investors will flee to more secure bonds, pushing prices down; if and when the economy slows, these bonds will look increasingly risky since it will be more difficult for the less than creditworthy debtor companies to service their debt as profits dry up, again, pushing bond prices down.  This phenomenon became quite apparent during the recent collapse in oil prices when a significant number of marginal oil companies saw the value of their bonds plummet by 50 percent or more.

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