One increasingly worried line of investment thinking is that demand for global equities is being fed in part by strong demand for corporate bonds. As central banks vie with ETFs and sovereign wealth funds to snap up the most liquid bonds, prices rise and yields fall. This encourages corporates to issue more debt, some of which is then recycled back into share purchase programmes. The plunging yield on corporate bonds also encourages investors to buy higher yielding equities. Equities sharply increase in value as a result.
In this scenario, any future stress within global stock markets might emerge initially in the corporate bond space. Two specific concerns have come to the fore in recent months. The first is that the boom in bonds is being fuelled by a very different kind of investor i.e more fickle investors who could sell out in a future panic. In addition, liquidity in the trading of these bonds might not be strong enough to allow for a sudden sell off, sparking market volatility which could impact on stock markets.
A recent paper looking at the micro dynamics of the corporate bond markets by analysts at Swiss bank UBS, finds some evidence for these concerns. Called “Macro keys – US Corporate debt”, the paper revisits some of the banks earlier analysis and finds that “US corporate credit spreads are near or at post-crisis lows, yields are within 30-50bp of all-time lows and credit market sentiment feels very firm. However, it is precisely these conditions that have raised financial stability questions and the potential risks lurking in US corporate sector”.
The UBS analysts specifically worry about the supply of long dated investment grade corporate bonds – they observe that there “has been a material rise in the number of lowest rated companies, with triple C rated issuers doubling to over 1,400. This phenomenon risks material credit losses for markets dominated by smaller issuers (e.g., middle market, private credit) if and when the cycle turns…… Historically, strong debt growth has often foreshadowed rising industry stress”.
On the demand side, the UBS analysts find that the key marginal buyers are “non-US investors, accounting for about 40% of total flows since 2014. These flows are likely to weaken, not exit – likely compelled by less attractive valuations, hedging costs and rising supply of other assets. Key risks include a material rise in credit risk. Today’s ownership structure is not as fragile as the financial crisis, but the accumulation of debt has been concentrated in hands that sold materially during the financial crisis (rest of world, funds, ETFs). And regulation has compromised market-making capacity to handle risk transfer, resulting in illiquidity in stress periods near levels seen in the financial crisis.”