Yield Bubble Intact and Inflating
Update: The ink has hardly dried on this, but it could seem as if short duration holders are starting to feel a little bit vulnerable here; you know, that flattening feeling!
A lot of questions to asked here, one of which is of course whether forward guidance is now no longer a trusted tool. Another more immediate question is of course how flat will the curve go here?
Emerging economies are reeling as rising US bond yields are squeezing the most vulnerable and funding intensive parts of the market. But the squeeze in EM yields is merely an hors d'oeuvre to what is likely waiting in the wings.
Consequently, Bloomberg had a fascinating piece this morning (no link available) about how the crunch in bank lending is pusing bond market debutants to a new high in Europe.
Corporate borrowers are making their bond market debuts at the fastest pace on record in Europe as bank lending gets squeezed by more stringent regulation. Italy’s Zobele Holding SpA and Greek refrigeration supplier Frigoglass SA are among 72 first-time issuers that have raised $39 billion of bonds this year, outstripping the previous high of $32 billion in 2012, according to data compiled by Bloomberg. Loans to companies in the region fell 8 percent in the first half and are 36 percent lower than the $598 billion recorded in the same period of 2011, data show.
“The decision was driven by liquidity in the banking market being tight compared to public bond markets, which also offered attractive terms and increased operational flexibility,” said Christopher Wood, chief financial officer at Trento, Italy-based Zobele. There was “positive momentum” in the bond market, he said, enabling the closely-held maker and supplier of household products including air fresheners and insecticides to diversify its funding.
There are some interesting themes to consider here in my view.
Firstly, the process of bank disintermediation is very interesting. We are seeing the same in emerging markets but where the process here is driven by capital deepening, the process in Europe is driven by necessity. The main consequence is that banks are "losing out" as companies are increasingly shunning the banking channel and turning to public issuances when it comes to finances. Of course, for the banks with an investment banking division to underwrite the issuances they may re-internalise the profits, but ultimately traditional business lending banking operations are being hurt here. Once a company has access to the debt market it is unlikely to go back to the bank. A second and potentially much more destabilising consequence is that the wave of new issuers is not well understood by investors hungry for yield. Mispricing risks are consequently rife.
Secondly, forget about yield crisis in EM. The big one is going to be high yield corporate debt in the US and Europe and this could kick off within the next 12 months in my view. The EM squeeze has given the illusion that the yield bubble is bursting. It isn't. Spreads still ultra-tight, covenant lite loans are on the rise, no covenants loans too, closely held companies difficult to analyze etc. This is a recipe for disaster for companies and investors alike. Default rates will rise and they will likely rise quickly but we are not there yet. Developed economies are currently looking up, but leading economic indicators do no rise forever.
Thirdly and perhaps most importantly, the big escape from duration has materialised itself in a surge in demand for the lowest rated junk bonds (which is usually variable rate and short duration).
Investors are eschewing bonds with the most to lose when interest rates rise as the Federal Reserve signals it may soon begin pulling back from unprecedented stimulus. A measure of sensitivity to changes in benchmark rates is at about a record high for AAA bonds, while it is holding below the average over the past 10 years for CCC debt, the Bank of America Merrill Lynch index data show.
“It’s a perfect storm,” Stefan Lingmerth, a New York-based analyst with Phoenix Investment Adviser LLC, a distressed-debt investor, said in a telephone interview. “AAAs are more interest-rate sensitive, while CCCs are hardly affected,” and investors are looking for more yield as the economic recovery strengthens, he said.
So let us sum this up. Variable rate, short duration HY debt is doing very well with plain vanilla long duration IG is suffering. The US corporate bond curve is now as steep as it has ever been and the reason is that investors are doubling up on the economic recovery hopes by moving down the risk structure essentially banking on low short rates for an extended period. You make the connection to the bursting of the bubble in yield. I can’t, it looks intact and inflating to me.