3. The Corporate Bond Bubble
Now let’s discuss corporate bonds. According to JPMorgan Asset Management, as of June of 2016, there were 4,333 stocks listed on U.S. exchanges. In comparison, according to PIMCO, there are over 300,000 corporate bonds issued and outstanding today. These typically trade over the counter and are non-standardized (meaning they have differing repayment seniority, covenants and indentures). PIMCO also shared that while the typical stock will trade 3,800 times per day, the most liquid corporate bonds only trade about 65-85 times a day. If liquidity were to begin to dry up like it did in 2007-2009, many bonds would not have a bid and could not be sold or only sold at fire sale prices.
The corporate bond situation has also been made precarious due to the amount of issuance brought on by the low interest rates primarily caused by the Fed’s purchases. With the Fed’s demand for bonds being added to the normal demand, yields fell to historic lows. This in turn allowed companies to issue bonds with very advantageous interest rates. Even companies with lower credit or re-paying capability have issued large amounts of debt at unnaturally low interest rates. As the chart below illustrates, a large gap or bubble has formed in the amount of debt issued by these company’s whose ability to re-pay may become stressed in more difficult economic times. As credit risks escalate, the yields on these bonds should rise to compensate for the extra risk. It hasn’t happened yet, but the gap is clear.
Another factor to know about is that the liquidity provided by the primary bond dealers today is much less than just a few years ago. As the chart below shows, primary dealer inventory is less than one quarter what it was at the beginning of the financial crisis. If the corporate bond desks ave smaller inventories and are less likely to buy or trade, this means liquidity ill dry up faster and yields are likely to rise, causing prices to fall, when we ave our next economic recession.
So why does this matter?
So why does this matter? Since 2009, bond purchases by the Fed have driven rates to historic lows. The money supply has ballooned. Primary liquidity of corporate bonds has been significantly reduced. These are massive structural changes to our bond markets and to our cyclical economic system. Interest rates peaked in the U.S. 35 years ago, back in 1981. Most people working in the financial services industry today are not old enough to remember the last time there was a bond bear market. Stagflation (slow or no economic growth with high inflation) is a text book term, not current lexicon. Will we see stagflation again?
We are not trying to predict the future but rather to stimulate thought around risk control in the bond markets. Much has changed at the macro level and it is always best that we all understand the risks and educate clients to the macro risks present in today’s bond markets. Disaster is far from certain, but caution and proper portfolio positioning in both equity and fixed income may be warranted sooner rather than later.
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