DESPERATELY SEEKING YIELD / THE ECONOMIST BUTTONWOOD COLUMN

Buttonwood

Desperately seeking yield

Investors are gorging on corporate bonds. Is an asset bubble being inflated?

Nov 10th 2012   
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THESE are good times for the corporate treasurers of large firms. They can raise money in the bond markets at the lowest cost in living memory (see chart).




Companies have been quick to take advantage of the opportunity. By the end of October global corporate-bond issuance for the year stood at $3.3 trillion, close to the record set in 2009. The pace has not slackened: Abbott Laboratories this week raised $14.7 billion, the biggest deal of the year, at maturities ranging from three to 30 years and with yields as low as 1.2%. The ease with which large companies can raise money is in sharp contrast to the plight of smaller businesses, which are still finding it hard to get finance from the banks.

 

 

 

 

 

With the return on cash close to zero, and government-bond yields in many markets near record lows, investors are indulging in another desperate “hunt for yield” akin to the one that sparked the subprime-mortgage boom before the crisis. According to EPFR Global, a data provider, bond funds have attracted a cumulative $395 billion since the start of this year, and almost $1.1 trillion since the beginning of 2008. In contrast, equity funds and money-market funds have seen net redemptions of $467 billion and $793 billion respectively since the start of 2008.




Those numbers are largely the result of retail flows but bonds also appeal to institutional investors. “Corporate bonds are probably the preferred asset class for insurance companies right now,” says Chris Iggo of AXA Investment Managers.



So far this year the bet has paid off. American corporate bonds have returned 9.4% and the high-yield (and thus higher-risk) portion of the market has returned 13.6%, according to Barclays Capital. However, the combination of investor enthusiasm, heavy issuance and very low yields naturally creates the possibility that an asset bubble is being inflated.



For investors, the risks are twofold. The first is that economies will dip back into recession and that more companies will default on their bond issues, forcing investors to suffer write-downs on their holdings. The credit risk of corporate bonds is reflected in the excess interest rate, or spread, they offer over government bonds. At the moment this spread is lower than it was at the start of the year and lower than its five-year average. But it is still well above the levels of 2005 and 2006, when the credit bubble was inflating.



There are some modest signs that companies may be struggling in the face of a sluggish economy. Standard & Poor’s, a ratings agency, has recorded 64 corporate defaults this year, compared with 35 at the same stage of 2011. Over the past 12 months the default rate on global high-yield bonds has been 2.7%, with the American default rate being slightly higher at 3%. But both numbers are well below the long-term average default rate of 4.5%, indicating that spreads are not particularly low given the fundamentals. They are much lower in Japan, where ultra-low returns on cash and government bonds have been a feature of the landscape for a decade.



The second risk facing bond investors is that the economy rebounds sharply. Central banks might start to increase short-term interest rates, prompting government-bond yields to soar and corporate-bond yields to rise (and prices fall) in tandem. One of the worst years for bond investors was 1994, when the Federal Reserve suddenly started to tighten policy after years in which it had held rates low to help the financial system recover from the savings-and-loan crisis.



For the moment, however, the global economy looks fairly sluggish; forecasts for GDP growth are being revised down rather than up. Central banks in the developed world may yet be forced into further policy easing. As a result, it is hard to see an increase in official rates in the near future. The Fed has indicated that it will keep rates low until 2015. Any rise in government-bond yields might well be met by a further round of quantitative easing to drive yields back down again.



Most investors who are buying corporate bonds need the income right now. They may well feel they can worry about the prospect of monetary tightening in 2015 much nearer that date. Of course, that creates its own risks. When the market does turn everyone will want to head for the exit at once, as was the case with mortgage-related bonds in 2007. That might turn a retreat into a rout.
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Of the two big risks, then, the credit risk associated with an economic downturn looks the greater danger in the short term. But it is not great enough yet to deter investors—which means the menace from interest-rate risk will only grow.