The desperate hunt for yield has left the corporate bond market vulnerable to interest rate rises. With US rates now climbing, things could get very painful, says John Stepek
Corporate bond investors pull out a record amount of money
The Office of Financial Research, set up by the US Treasury in the wake of the financial crisis, has highlighted a number of things to be worried about.
The corporate bond market is the biggest area of concern. As well as obvious problems such as emerging-market debt, "credit risk in the US non-financial business sector is elevated and rising" too. In other words, while the banks might be healthier than they once were, there are too many poor-quality loans to companies outside the financial sector out there.
Meanwhile and this is perhaps less widely understood the desperate hunt for yield has made the average bond portfolio more vulnerable to rising interest rates than ever before. As Tett notes, "duration" (which indicates just how badly affected a bond portfolio by rising interest rates) is at "historic highs".
Finally, the financial plumbing has been damaged by near-zero interest rates. This quickly gets technical, and we'll delve into it more deeply another time, but basically the Fed can't rely on the same tools that it would once have used to raise rates. That means there's more scope for mistakes and unintended consequences.
And make no mistake, while equities have shown little sign of concern, bond investors are edgy. Reported elsewhere in the FT this morning: "Investment grade bond funds in the US have been hit with a record wave of redemptions", according to data from Lipper.
Investors have pulled $5.1bn from active funds and exchange-traded funds (ETFs) that hold investment-grade bonds. That's the biggest withdrawal on record since 1992 and, to be clear, this is not junk, this is the half-decent stuff. Junk saw $3.8bn pulled out in the same week.
It doesn't matter that rates are still at or near historic lows. The market got used to rates being at these levels. All the resulting mal-investment needs to be unwound. It remains to be seen just how painful that will be.
The Japanese central bank acts again
Haruhiko Kuroda, the Japanese central bank boss, decided to buy Japanese government bonds with longer maturities. It'll now buy those maturing in up to 12 years, rather than just ten. The Bank is also going to buy exchange-traded funds that hold stocks in the new JPX-Nikkei 400 index.
This last is not as big a deal as it might sound. The Bank of Japan has been buying equities for a while as part of its quantitative easing programme. The shift here is in focus. The JPX-Nikkei index only holds companies that meet certain shareholder-friendly criteria it's all part of the government's efforts to improve corporate governance in Japan.
None of this is about adding to the overall amount of money being printed. If anything, the market was a little underwhelmed. But it does emphasise the divergence of direction. As the Fed is pulling in one way, Japan continues to look for ways to ease. It's another reason I'd be more comfortable hanging on to Japanese stocks than US ones for now.
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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.
He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.
His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.
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