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"Start getting ready for the corporate bond crash"

4 Oct 2014 by Jim Fickett.

I have been writing for some time that there is a major bubble in poor quality corporate credit, and that this weak point in the markets could play a role in the next downturn (Comparing subprime corporate and subprime mortgages).

In addition to a widespread concern that junk bond interest rates may have gone too low (even Janet Yellen has said, “Corporate bond spreads … have fallen to low levels, suggesting that some investors may underappreciate the potential for losses and volatility going forward”), there is a concern among dealers that, as an unfortunate side effect of recent regulatory changes, liquidity in the bond markets has decreased significantly. Of course if rates rise and prices drop, a lack of liquidity could spark a panic. Blackrock, the asset management company, recently issued a report in which they analyze the causes of decreased liquidity, and suggest market reforms. In the conclusion to this report, they say,

The low interest rate, low volatility environment, coupled with the impact of QE on the credit markets, masks the amount of change that has occurred in the corporate bond market as decreased liquidity and the shift from a principal market to an agency market takes hold. A less-friendly market environment will expose the underlying structure as broken, with the potential for even lower liquidity and sharp, discontinuous price deterioration.

Most of us have a simpler word for “sharp, discontinuous price deterioration”. John Dizard, columnist at the FT, is blunt about it:

The Obama administration, Congress, and the Fed better start getting ready for the corporate bond crash. That is the message that BlackRock and other asset managers are trying to get across.

“It's tough to make predictions, especially about the future.” But investors should certainly take note of the danger.