Every citizen of the western world must by now know that credit bubbles can and do burst dramatically when overstretched borrowers miss payments, leading to losses among the investors who provided the debt. However, after a four-year bond market rally driven by zero interest rates and money printing from central banks, the inevitable prospect of higher rates, known as duration-risk in bond trader parlance, now poses a far greater threat to corporate bond investors than borrower default.
With demand for US Treasury’s anchored by the Federal Reserve Bank’s bond-buying programme, which has grown its Treasury holdings to an all-time high of $2.9 trillion since the programme began in December 2008, fixed-income prices have risen substantially, attracting a deluge of institutional and retail money into the asset class.
Yields available in government bonds, investment-grade corporate credit, and high-yield and mortgage bonds are now so thin that global banking regulators and credit rating agencies have recently published a series of warnings that a sharp rise in interest rates – driven either by policy rates or Treasury market moves – could lead to heavy losses for many investors. In the words of the legendary co-founder of Pimco Bill Gross: "In the credit markets, when money yields close to zero, it is destructive, not constructive."
US Treasury investors are particularly at risk, as the volatility in 10-year yields, and prices, in the first few days of trading in 2013 demonstrates. Initial market reactions to the December deal to push back the fiscal cliff, combined with the release of Fed minutes that highlighted growing discomfort with the open-ended nature of quantitative easing, drove 10-year yields sharply higher, from 1.7% to above 1.9% in a matter of days.
In anticipation of this back-up in yields, bank research departments have become bearish on the treasuries, and investment-grade credit in general.
It is important not to underestimate the market-moving power of the Fed and other central banks. Although yields spiked up, continued buying by the Fed and the Bank of Japan has limited the move up, with 10-year yields stalled around 1.85%. However, as Federal Reserve board members become more vocal about the need for the Fed to exit the Treasury market, the short- to near-term prognosis would seem to be more volatility and higher rates.
Although insurance companies and other investors that hold securities for the long term use asset liability management techniques to mitigate the risk to bonds associated with rising interest rates, other shorter-term, trading-focused investors are not so prepared for the coming turbulence.
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The pain could be severe. According to Fitch Ratings, a typical BBB-rated 10-year US corporate bond could lose 15% of its market value, if interest rates were to rise quickly. Losses on 30-year bonds could reach 26% if rates returned to early-2011 levels, the agency said in a recent study. The European bond market is similarly stretched, with surging demand for any investment that offers a margin over government bonds and money markets. Last year, investors poured €21 billion into European investment-grade credit mutual funds and exchange-traded funds (ETFs) – the latter group of funds posting more than 40% growth in assets under management on 2011, according to global fund data provider EPFR.
Supported by these surging capital inflows, the cost of issuing debt for the average single-A rated European corporates fell from a spread of around 2.3% at the start of 2012 to less than 1%, according to the iBoxx Euro Corporate index, published by London-based data provider Markit.
Moreover, after pressure from the banking industry, amendments to capital rules allowing banks to include corporate debt in their capital ratios look set to extend the bond market rally into 2013, other things being equal.
According to Jim Nolan, managing director and head of investment-grade trading at Babson Capital Management, a Boston-based investment company with more than $160 billion of fixed-income assets under management, while US Treasury yields have been influenced more by central bank activity than by underlying fundamentals in the US economy for several years, one could argue that corporate balance sheets continue to enjoy much better health than Uncle Sam.
“Although US corporate credit fundamentals may have peaked in this credit cycle, they continue to be very strong,” he says. “While we may see some modest deterioration in credit conditions, we don’t expect that to significantly impact where credit spreads are today.”
That is not to say, however, that there won’t be some casualties in the corporate credit market in 2013 and beyond. One of the main themes arising from years of central bank accommodation has been the influx of new money into fixed-income investments, especially from ETFs offering retail investors targeted bond exposures.
“Any losses from interest rate moves could see these flows go into reverse, and that could clearly have an impact on spreads in the corporate market,” says Nolan.
Specialist asset managers with more developed risk-management strategies are standing by to take up the slack. “Any back-up in spreads from current levels will almost certainly attract insurance companies and pension funds to the market, so long as fundamentals remain intact,” he concludes.
Others are less bullish. In the words of Gross: "All assets are artificially "bubbled" and the trick to to find out which ones are less bubbled", however, in a zero-bound world "real price appreciation [in some areas of the US investment-grade credit market] is getting close to mathematically improbable".