Authored by Jason Shoup of Citi Credit,
Looking for the ‘just right’ level for rates
Indeed, we’d argue that the Fed’s zero lower bound policies have dislodged credit risk as the primary concern for investors, only to replace it with a major technical headache: interest rate risk. Granted, rates could rise in an orderly fashion and drive spreads tighter from here - the ‘just right’ scenario that remains our base case. But there is the probability that Treasury yields do otherwise pose serious risks to the market, as we have started to observe in recent weeks. What’s more, the risks are in both directions.
Too low for too long …
If rates remain too low for too long, financial stability suffers as investors reach for yield, companies lever up, and lending standards decline. In early February, Federal Reserve Governor Jeremy Stein pointed out that many of these concerns are already visible in high yield where covenant-lite issuance has exploded, yields on triple-Cs are at all time lows, and CLOs have returned in force. Similarly, investment grade companies have been relevering at an alarming pace, banks are reportedly making ever dodgier C&I loans, and the mega-LBO is back.
What’s more, a look to Japan illustrates the dangers of allowing these imbalances to build. As JGB yields have started to rise after being depressed for so long, concerns have emerged about the health of the Japanese banks, which generally hold longer duration bonds in their security portfolios than their US peers—presumably a function of having to cope with low rates for so long. And a handful of major Japanese corporates have pulled new deals as rates have gapped higher as well, suggesting they too have become dependent on low rates.
Still, the greatest of financial stability risks is probably the least discussed among those that matter at the Fed: the deterioration in trading volumes.To the credit of the Street, trading in corporate bonds hasn’t declined much in outright terms. But the corporate bond markets have grown so rapidly as a result of the Fed’s zero lower bound policy that the sell-side’s ability to transfer risk just hasn’t been able to keep pace, which could potentially spell disaster if investors all choose to sell at once. One can clearly see this in the steady decline in market turnover over the last few years (Figure 9).
Finally, a less diverse investor base, or conversely one in which everyone is in the same trade, can also be seen as a financial stability concern and a direct byproduct of rates staying low for an extended period of time. To our minds, little diversity among investors raises the risk of overshooting in both directions: first as yields compress to abnormally low levels, and then as all investors race for the exit all at once.
As such, we suspect that the longer low rates persist, the worse the unwind of QE may be. And it may, in fact, already be too late.
… or too high too quickly
As events in the past two weeks have shown, credit markets appear vulnerable to a rise in rates that occurs too quickly or in a chaotic fashion. What’s more, there’s an air of inevitability to it all, suggesting that even though market participants can see what’s coming, there’s little that can be done.
Part of the problem is that investment grade credit has increasingly become more sensitive to total returns during the past five years as the AUM of mutual funds dedicated to bonds have rapidly grown. Using Fed data, we reckon that the percentage of the corporate bond market that mutual funds now own is roughly 17%, up from about 12% in 2007. Likewise, cumulative inflows into high yield mutual funds have been similarly impressive in the period after the great financial recession.
Yet the reliability and stickiness of mutual fund flows going forward is definitely a wildcard, to our minds. At the very least, it’s hard to envision that bond funds will continue to attract the same level of inflows that they’ve enjoyed since 2008 when faced with expected future total returns that are likely to be exceptionally low, if not negative. Indeed, in such an environment, there’s a very real possibility that fixed income funds experience outflows when retail investors fully appreciate the upside limitations in bonds as the economy recovers. In fact, some major funds are already seeing redemptions on the back of May’s performance.
To get an idea of how significant the retail flow situation might become, we find it instructive to look at credit ETFs as a guide. Assets under management at LQD - an unhedged IG ETF - have dropped by nearly 15% since mid-December, forcing the fund to sell roughly $3.9bn of corporate bonds through the redemption process. By comparison, if mutual funds were to experience an outflow of the same magnitude, they’d need to sell upwards of $100bn of corporate bonds.
To our minds, that amount of selling could be exceptionally disruptive to valuations if (1) it occurred over a relatively short time period, (2) institutional investors were unwilling to take the other side, and (3) the Street was unwilling to increase their inventory of bonds.
Moreover, to the extent that issuers sense demand may be waning for bonds, there’s a distinct possibility the pace of supply increases precisely at the same time that demand decreases. In the high yield markets, for instance, companies have become far more proactive at taking callable bonds out with make wholes in order to issue low coupon longer-dated debt. Similarly, we expect that a number of high grade issuers debating doing a liability management exercise, an acquisition, or simply prefinancing 2014 maturities, may be persuaded to come to market sooner rather than later as rates show signs of permanently moving higher.
Invariably, it’s the sort of dynamic that ends in tears.