The corporate bond market is getting jittery

The US Federal Reserve’s move to raise interest rates this week didn’t immediately result in the financial end of days.

As a result, financial commentators everywhere have rushed to congratulate the Fed on a job well done.

That might be a teensy bit premature…

Corporate bond investors pull out a record amount of money

As Gillian Tett notes in her FT column today, the “market reaction to the Fed might seem impressively calm, but the real test for the wider financial system has barely begun”.

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

While we’re on the topic of central banks, Japan pulled a surprise this morning.

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.