The ‘hunt for yield’ is getting way out of hand
Alan Greenspan, the former chairman of the Federal Reserve, is not ideally placed to opine on the threat posed by asset bubbles in financial markets. This is, after all, the central banker who is widely blamed for having sewn the seeds of the 2008 global financial crisis by refusing to prick the US housing bubble which triggered the crash.
Yet Greenspan’s words still carry a lot of weight with market commentators and investors. So when he warned in an interview on Tuesday that “we are experiencing a bubble, not in stock prices, but in bond prices” which “is not discounted in the marketplace”, it received a lot of attention.
While there is intense debate, as I explained in an earlier column, about how debt markets will fare once other leading central banks – in particular the European Central Bank – join the Fed in withdrawing monetary stimulus, the fierceness of the decline in bond yields stemming from international investors’ voracious appetite for higher-yielding assets is indisputable.
The “hunt for yield”, which has intensified since the yields on a large portion of the stock of government debt in Europe and Japan turned negative due to aggressive programmes of quantitative easing, has become one of the most conspicuous trends in markets over the past several years, and one that is setting off alarm bells.
According to data from Morningstar, investors poured a staggering US$355 billion into bond funds in the first five months of this year – compared with US$375bn in the whole of 2016 – despite mounting concerns that debt markets are vulnerable to central bank missteps, with a bond market crash cited as the biggest “tail risk” in the latest fund manager survey by Bank of America Merrill Lynch. Moreover, a significant portion of this money was directed to funds investing in US and emerging market debt.
Spreads, or the risk premium, on investment-grade US corporate bonds have narrowed to their lowest, or tightest, levels since mid-2014 and, more worryingly, are now only some 10 to 15 basis points higher than their historical lows, according to data from JPMorgan. The plunge in the dollar this year has increased the appeal of dollar-denominated assets, with foreign investors purchasing US$26bn of US corporate bonds in May, the largest monthly inflow since 2009, according to the Financial Times.
Moreover, in a sign of investors’ willingness to move up the risk curve, spreads on the safest category of US high-yield, or “junk”, bonds have fallen to just a couple of basis points above their historical lows.
Yet the asset class where the “grab for yield” is fiercest is emerging markets.
Inflows into emerging market bond funds since the start of this year have surged to US$68.5 billion, compared with US$43 billion for the whole of 2016, according to JPMorgan. If the current pace of purchases is sustained, this year’s inflows could exceed the record of US$103 billion set in 2010.
The reach for yield is most apparent in the corporate bond markets of developing economies. Ravenous demand for emerging market debt has caused spreads on both investment grade and high-yield corporate bonds to narrow to levels that are close to their historical lows, and significantly below their tightest levels since the global financial crisis, according to JPMorgan. Yields on Latin American junk bonds have plunged more than 100 basis points this year and are now slightly above their record lows.
Make no mistake, emerging market corporate bonds entered bubble territory quite some time ago.
What is particularly troubling is that there is no indication that the hunt for yield is likely to abate – indeed, quite the opposite.
Given ultra-low borrowing costs in developed markets – almost a fifth of the stock of global sovereign debt is negative-yielding, with nearly 30 per cent of eurozone bond yields in negative territory, according to JPMorgan – investors have little choice but to move into riskier asset classes in order to generate adequate returns.
Yet the fiercer the hunt, the larger the bubbles and the greater the risk of a sharp and disorderly correction in bond markets if investors get spooked by the removal of monetary stimulus.
For the time being, market sentiment remains buoyant.
On Wednesday, the Dow Jones Industrial Average briefly surpassed the 22,000 mark for the first time due to stronger-than-expected profits from Apple.
Yet as Greenspan warned, it is not equities that are in a bubble, it’s bonds.
Nicholas Spiro is a partner at Lauressa Advisory