IMF warning on US corporate bond markets

20 Oct 2014 by Jim Fickett.

The International Monetary Fund recently issued the latest Global Financial Stability Report, and highlighted in a blog post the risk in US corporate debt:

Heat Wave: Rising Financial Risks in the United States Posted on October 10, 2014 by iMFdirect

By Serkan Arslanalp, David Jones, and Sanjay Hazarika

Six years after the start of the global financial crisis, low interest rates and other central bank policies in the United States remain critical to encourage economic risk-taking—increased consumption by households, and greater willingness to invest and hire by businesses. However, this prolonged monetary ease also may have encouraged excessive financial risk-taking. Our analysis in the latest Global Financial Stability Report suggests that although economic benefits are becoming more evident, U.S. officials should remain alert to excessive financial risk-taking, particularly in lower-rated corporate debt markets.

… financial risk taking in corporate debt markets is rising and markets have begun to overvalue many assets. Spreads in the high-yield and leveraged loan markets are not far from levels seen before the financial crisis. The quality of new loans issued is also declining, especially in the leveraged loan market where the amount of leverage in new deals is rising. The number of “covenant-lite” deals which give lenders less control over issuers has increased. For example, many new deals allow borrowers to issue more debt in the future without obtaining prior permission from lenders.

Meanwhile, the risk that many investors could sell their holdings all at once is now even higher than before the crisis. Mutual funds, exchange traded funds, and households hold about 30 percent of corporate bonds as of the end of June 2014.The worry is that such “retail” investors could start selling suddenly if the value of their assets deteriorates unexpectedly.

Note that if the US junk bond market is the source of the next crisis or bear market, as I think likely, there may be no warning. In the last crisis there was general awareness among banks and hedge fund managers that there was a problem brewing in the mortgage markets, but the general public was blithely unaware. That made it possible for the informed investor to watch what was happening in the banks, and get some warning of the crisis. But in the current situation all investors know the market is overvalued, and everyone is watching everyone else to guess when the stampede will start. Once it does, it will be too late.