The low interest-rate environment on both sides of the Atlantic means people still remember the famous quotation from Charles Prince, former Citigroup chairman: “As long as the music is playing, you’ve got to get up and dance.” Bear in mind he said that shortly before the financial crash of 2007-2008.
Today’s situation is nowhere near as bad as it was then, when investors ploughed blindly into extremely risky financial vehicles, even as the property market began to wobble. By comparison, the economic situation on both sides of the Atlantic today is very good, and default rates for corporate debt are currently falling. But there are unmistakable warning signs that an insatiable appetite for corporate bonds will not do investors much good for much longer.
The numbers to date are impressive: Since January, companies in the United States and the euro zone have raised more than $1 trillion on the bond market, making 2017 a record-breaking year for corporate bond issuance. But most investors don’t feel entirely comfortable with the situation. “Everything is expensive,” complained Sebastien Page, head of asset allocation at the American fund manager T. Rowe Price.
This is the classic financial conundrum in a nutshell: Everyone knows that risks have increased enormously, but no one wants to cut and run from their positions just yet. Instead, the low interest-rate environment on both sides of the Atlantic means companies are making a killing asking for cheap cash, while the pressure for investors to generate yield remains enormous. But with central banks about to pull the plug, all of that sounds suspiciously like the last hurrah for corporate bonds.
“At this level of risk premiums, we’re collecting small change in front of a moving steamroller.”
Robert Michele, head of bonds at JP Morgan Asset Management, put it most vividly: “At this low level of risk premiums, we know we’re collecting small change in front of a moving steamroller.” It’s a shift that markets are “not yet adequately prepared” for, according to a committee of the US Treasury. That same unpreparedness may also be true of a looming shift in monetary policy in Europe.
That shift comes after years of easy money. Central banks have underlain the steady climb in bond prices, and the corresponding fall in yields, ever since the 2008 financial crisis. On both sides of the Atlantic, central banks have cut interest rates and bought trillions of dollars worth of bonds, in order to stimulate the economy and a healthy level of inflation at a time when Europe and the United States looked headed into the abyss.
With the economy nursed back to health, the Federal Reserve, the American central bank, is in the middle of a rate-raising cycle. Investors expect only one more hike this year – most likely a quarter point from 1.25 to 1.5 percent – but the Fed also intends to invest less money in maturing bonds in 2018, with a view to gradually reducing its massive $4.5-trillion balance sheet. The European Central Bank, or ECB, isn’t that far behind. It’s true that a raising of base interest rates – currently at zero – by the guardians of euro-zone monetary policy seems very distant. A separate short-term rate known as the deposit rate, which commercial banks must pay the ECB to park their money, will also likely remain negative for the foreseeable future. But the ECB, led by President Mario Draghi, does intend next year to scale back its €2.3-trillion bond-purchasing scheme as early as the start of 2018.
Companies are well aware that times are about to change. Dan Mead, an investment banker at BofA Merrill Lynch, sums things up: “Companies are trying to gain access to money before it becomes more difficult.” Company valuations are high, which means that yields and risk premiums for investors are low. Add to that the headwind from central banks, and it doesn’t take a financial whizzkid to realize that bond prices are soon likely to fall and yields and risk premiums will turn upward.
It’s one thing to know it’s coming, another to be ready for it. In recent months, mere mentions of the possibility by the ECB have provoked strong reactions on the markets. For now, investors are still gratefully lapping up these mega-bonds. Between the end of July and the beginning of August, AT&T, British American Tobacco and Amazon alone raised over $57 billion in new debt. In Germany, Volkswagen and Deutsche Bank are examples of troubles companies that managed to raise €8 billion each earlier this spring.
Central bank operations have led to bizarre distortions of the market.
The low- and negative-interest rate environment has also forced investors into ever-more risky asset classes. This has led to bizarre distortions of the market. Risk premiums – in other words, the extra cost of riskier corporate bonds compared to ultra-safe American or German government bonds – have fallen so sharply that they are now at levels last seen just before the financial crisis.
This is true on both sides of the Atlantic, and almost regardless of companies’ credit ratings. In the euro zone, the distortions are particularly marked. Here the ECB is not only buying government bonds but also investment-grade corporate bonds, in other words bonds from well-rated companies. Yields in this part of the market have sunk to an average of just 0.8 percent, corresponding to a risk premium of 0.9 percentage points. This in turn has led to increased demand for the riskier bonds of companies with poorer credit ratings, which the ECB will not buy. The result has been a fall in the average yield on European junk bonds to just 2.3 percent, an all-time record. This is around the current yield on US state bonds, albeit ones with long maturities.
But what happens when the ECB pulls the plug? Asset managers like Deutsche Asset have already begun to reduce the proportion of euro-denominated junk bonds in their portfolios. JP Morgan Asset Management is another market player which believes that investors no longer achieve adequate reward for their risk on European junk bonds. That could be a mild foretaste of what will soon hit the market as a whole.
Andrea Cünnen works at Handelsblatt’s finance desk in Frankfurt, reporting on the bond markets. Brían Hanrahan and Christopher Cermak adapted this story for Handelsblatt Global. To contact the author: firstname.lastname@example.org