THIS column has long highlighted the massive bubble in the global bond markets and the horrific, systemic risk it poses to the global recovery and financial system. A combination of ultra-low central bank short-term interest rates, massive amounts of quantitative easing (QE), regulatory-driven purchases of government bonds by financial institutions and Asian forex accumulation have all conspired to push yields far lower than they should be and bond prices far higher.
Recent shifts have barely dented this bubble; when the sell-off eventually comes, and yields shoot up, the shock to global businesses, individual borrowers and governments will be immense.
But while the basic story is straightforward, further analysis keeps showing that the bubble is even greater than usually understood, and extends to new areas. Just like with the credit crunch of 2007-08, the story’s epicentre is in the US but its manifestations and causes are global. In an excellent analysis of the American situation, Larry McDonald and Robbert van Battenburg of Newedge show that there have been huge inflows of money into fixed income-like investments such as corporate credit since the crisis, with only limited amounts of money flowing into equities (and those stock market sectors that have attracted the most capital have been the most leveraged ones, including utilities and real estate investment trusts).
The issue is not merely one of debt versus equity. In the past, investors who wanted to hold credit often picked government bonds or mortgage-backed securities (MBS), both highly liquid asset classes. The problem is that these two areas are also those favoured by the Federal Reserve’s QE – and especially when it comes to MBSs, investors have been squeezed out by official purchases and forced to turn to riskier, less liquid alternatives.
One of the many unintended consequences of QE, therefore, is that assets in mutual funds that invest in bond, credit and high yield have rocketed since 2007; assets in high yield exchange-traded funds (ETF) (focusing primarily on corporate/mortgage bonds) have grown even faster. And still it continues: there was a $1.7bn inflow into leverage loan funds last week, a new record in notional terms. The figures are scary: inflows into junk bonds are up by 80.5 per cent since 2008, for example.
When the bubble bursts, owners of all kinds of bonds will be hammered, including of course Treasuries. But to make matters worse, the fixed-income like investments that the private sector has fallen in love with are highly illiquid. In most cases, a few thousand units of each investment grade and junk bond are traded every day; by contrast, volumes in the benchmark cash Treasury bond can easily be above $100bn. So when the crash does come, investors will all try to sell at once, liquidity will evaporate, prices will undershoot and plummet, and panic will set in. It will be a case of 2008 all again, with corporate bond yields and mortgage rates shooting up, exacerbated by the fact that the Dodd-Frank financial regulations mean banks can no longer act as counterparties in those markets in any significant way – they have largely been frozen out. So yes, there’s a massive bond bubble – but the details are even worse than the big picture.
QE has had another effect which is rarely quantified. The Newedge study calculates that 47 per cent of all S&P 500 earnings growth since 2009 has been derived from the interest expense savings from declining interest rates, a large chunk of which has been created by the Fed’s interventions. A puncturing of the credit bubble would send the cost of borrowing shooting up, and thus reverse many of these gains.
The problem with bubbles is that nobody knows when they will burst – but when this one eventually does, perhaps when tapering begins in earnest, there will be very few safe havens from which to ride out the chaos.