In its most recent quarterly report, the BIS said: “Some asset prices started to appear highly valued in historical terms relative to indicators of their riskiness. For example, global high-yield corporate bond spreads fell to levels comparable with those of late 2007, but with the default rate on these bonds running at around 3 per cent, whereas it was closer to 1 per cent in late 2007”.
Corporate and sovereign debt issuers have taken advantage of this apparent risk pricing disconnect to ramp up their borrowing. The BIS remarks particularly on the disproportionate increases in sub-investment grade issuance.
The warning from the BIS has particular resonance, as it is seen as one of the few institutions to have sounded the alarm bells in the run up to the 2008 crash. As investors reaped the profits of a cheap credit-fuelled boom, William White, the then chief economist of the BIS, published a paper called “Is Price Stability Enough?” He highlighted the risks of a focus on aggregate measures in the economy, like the overall measure of inflation, and warned that they had historically provided an inadequate bellwether for identifying emerging macroeconomic problems.
The BIS occupies an arguably anachronistic space within international finance. The Swiss-based institution was originally set up in 1930 as a vehicle to distribute reparation payments made by Germany after the First World War. It faced abolition during the Bretton Woods discussions as an obsolete organisation, but received a reprieve by US President Harry Truman and the British government and evolved into a club of central bankers.
It is these central banks that are the target for some of the blame for the asset risk pricing disconnect. Whereas the yields on a sovereign debt issuance would usually move broadly in line with the economic growth prospects of the underlying issuer, the large-scale interventions by central banks in the work place have fractured this connection. This is particularly true of those carried out by the US Federal Reserve and the Bank of England as they pump their respective economies full of cheap money.
In September, the Fed rolled out open-ended quantitative easing, committing itself to monthly asset purchases of $40bn (£26bn) until the jobs market saw a significant improvement. With the labour market still limping along, it unlikely that this “QE infinity” will come to an end in the next year.
Corporate bonds are experiencing a similar trend to that of sovereigns, but with default rates of just over 1 per cent compared to 0.5 per cent in 2007. The BIS reports that numerous bond investors felt less well compensated for risk than in the past, but that “they had little alternative, with rates on many bank deposits close to zero and the supply of other low-risk investments in decline.”
The BIS report does not cite ancient history. The crisis from which the global financial sector has yet to recover began its implosion five years ago. And as loose monetary policy keeps rates artificially low and cheap money inflating asset prices, investors should take heed of the BIS report and of events of the very recent past.