Daniel Lacalle

The Big Bond Bubble

Disminuir tamaño de fuente Aumentar tamaño de fuente Texto Imprimir esta página
“Artificially pushing interest rates down and forcing investors into junk bonds has only one end. It’s just a case of when, not if “(Sohn Investment Conference).

The slump of bond yields seen recently is not the result of the successful policies of our governments. We have seen most growth estimates revised down in recent months. We are seeing a “bond fever” worldwide.

Greek ten year bond yields have fallen to pre-crisis levels, Portugal is back in the capital markets, Rwanda issued a 6.8% bond, junk is trading at historically low rates, companies at risk of bankruptcy issued debt at 3.5%, … All this is not a coincidence. It’s the perception that the environment of artificially low interest rates and extreme liquidity will remain.

Low rates create a blind race to “seek yield” which always ends badly, because it encourages reckless behaviour of issuers thinking that everything is fine and it pushes banks and investors to close their eyes and take risks that were previously deemed as unacceptable. Then we go back to bailouts and “too big to fail” problems. Courtesy of central banks and their expansionary policies.

It seems that our central banks and states do not want to avoid another bubble. They want to replicate it.

This leads to build up in risk and leverage, while investors are accepting lower quality assets in exchange for lower returns.

The question is not “how it ends”, which we have seen in 2001 and 2007, but “when”.

It’s like the Roadrunner cartoons. The Coyote climbs up the cliff until he passes over the edge, keeps running and suddenly finds that under his feet there is nothing. The risk today is very similar.

This week the U.S. junk bond index has reached the lowest yield of the last thirty years. “High yield” is now an average of 4.95%.

Adding to this picture, debt accumulated by investment funds has reached record levels , doubling in two years while assets under management have grown just c15%.

However, our leaders across the OECD, instead of worrying and taking urgent action to avoid this bubble, see the decline in bond yields as a  sign of “restoring confidence”.

Do not forget that stock markets and bond yields also reached euphoria levels in 2001 and 2007, as economies plunged into the abyss.

I am convinced that the level of risk that is currently building up in the markets is disproportionate to the quality of assets.

How to create the bubble

The steps are:

  • Since 2007, central banks have lowered rates 511 times. Today most countries with high quality credit trade at very low yields, 1 or 1.5%.
  • Meanwhile , the credit quality of sovereign and corporate debt suffers because economic prospects do not improve. We have lost more than a trillion dollars in assets with maximum guarantee (triple A) during the crisis.
  • The rate of defaults has also gradually increased , albeit at low levels due to the liquidity frenzy. Junk bonds have a default rate of around 3.5%, and the default risk of several European countries has also increased 12% recently.
  • In that environment, pension funds are unable to generate the dividends they need to give to their customers buying only high quality bonds, which leads them to accept greater risk. The most serious problem is that they also accept low conditionality, ie, very soft credit requirements.
  • Because of this “thirst for yield” demand, countries and companies issue debt like crazy without improving fundamentals, taking advantage of lower interest rates.

What if there was no bubble?

Moody’s, the rating agency, and some banks were quick this week to say that “there are no signs of bubble in bonds.” Unfortunately, their past predictions have been less than successful.

The arguments against the bubble are:

  • The spread with quality debt is unchanged . That is, although the yield of all high-risk bonds has dropped it has also fallen proportionally in high quality debt. The problem that I see with this argument is that it fails to mask an overall situation of manipulated prices, soaring debt and weak growth.
  • Western economies are recovering. However, there is no solid data to support this claim. Growth in Europe, including the UK, is atrocious and the United States remains anaemic, and debt continues to grow while downgrading global growth estimates (from 4% to 3.3% overall).
  • Central banks will continue to print and lower rates as needed. This only has a problem. In previous bubbles rates were not at 0.5% and deposits at zero percent. And economies, private and public, were not so indebted … Investors were not so exposed to the market (see the chart below on the impact of expansionary policies in the stock market).  The placebo effect of monetary policy laughing gas lasts less than before.
While the snowball of high risk bonds continues to grow, both sides are engaged in the discussion of low inflation … Forgetting the monstrous asset inflation that is being created, and ignoring that monetary policy  accompanied by tax increases and financial repression makes consumption fall.What if there is a bubble?

Taking advantage of the relaxation of the conditions that investors demand in an aggressive monetary policy environment sounds good if one prepares for the winter taking drastic measures to reduce financing needs.

If this bubble bursts, it will do so with heavily indebted companies, governments and funds, ie, with very low capacity to absorb a sell-off shock. And if refinancing needs continue to accumulate the “vacuum” effect can lead to huge problems.

Too much risk for little return.

Investors and banks are taking too much risk. Balance sheets are not being cleaned and if this bubble is real  the effects can be disastrous.

If this pyramid of cards suffers the smallest shock , we will repeat 2007. But meanwhile, we are not cleaning the economy of unproductive sectors and taking the reforms needed to ensure sustainable growth .

Bubbles are relatively easy to identify, especially when they are created so quickly. When will they burst, in a manipulated market, is less evident. The belief of many funds and banks is that central banks are going to hold risky assets up because they do not “see bubble risk”.

And therein lies the problem . The worst of these bubbles is that it’s presented with a “social” veil. “Reducing Unemployment,” “support credit flowing” or “encourage growth” , when all they do is support banks and indebted states and push the most cautious investors, pension funds, to high-risk behaviours. Citizens do not see a dime but should rejoice at the “perceived wealth” and “trust” improvement.

There are many investors warning of this situation . Of course, they can be wrong. But states, rating agencies and central banks never see bubbles. Remember the technology or real estate ones. They spent more time justifying them than analysing how to get out. We’ll see what happens.

This article below was published in El Confidencial in Spanish.

Deja un comentario

Tu dirección de correo electrónico no será publicada. Los campos obligatorios están marcados con *