Market volatility has not quelled the appetite for risk, with subprime mortgages back in demand
Nicholas Spiro says the robust demand for products that led to the 2008 financial crisis indicates that market sentiment remains confident, despite the recent turbulence
The benchmark S&P 500 index, which in the first three weeks of this year shot up 6.5 per cent following a 20 per cent surge in 2017, finished the first quarter of this year in negative territory – its first quarterly loss since 2015. According to Bloomberg, the index has moved more than 1 per cent in either direction 22 times this year, three times the figure for the whole of 2017. Other equity markets, including those of Germany and Japan, are also in the red.
Further indications of turbulence can be seen in the prices of government bonds. Having flirted with the psychologically important 3 per cent level – a four-year high – as recently as February 21, the closely watched yield on the 10-year US Treasury bond has since fallen nearly 25 basis points, to 2.73 per cent.
Yet, below the surface of increased volatility, there are plenty of signs that international investors’ risk appetite remains strong.
The clearest example of this is the renewed demand for risky products blamed for contributing to the 2008 global financial crisis.
US subprime mortgages, the high-risk housing loans to people with poor credit histories, are back in vogue. According to Inside Mortgage Finance, a publisher of data on the US residential mortgage market, issuance of securities backed by riskier US mortgages doubled in the first quarter of 2018 to US$1.3 billion, twice the amount issued in the same period last year. Issuance could surpass US$10 billion this year, compared with just over US$4 billion in 2017.
Other products tarnished by the financial crisis are also back in fashion.
Complex structured investments, securities that rely on financial engineering to juice up investors’ returns, are all the rage. Last year, sales of so-called collateralised loan obligations – bonds that group together leveraged loans made to companies – surpassed the pre-crisis peak set in 2006, according to a report in The Wall Street Journal.
What is more, demand for these riskier products is coming from large institutional investors, such as European pension funds and Asian insurance companies, as part of a fierce “reach for yield” stemming from persistently low returns on government and corporate bonds. Despite the recent tremors in debt markets caused by fears about a faster-than-expected withdrawal of monetary stimulus, bond yields remain at extremely low levels, with more than 15 per cent of advanced economies’ stock of sovereign bonds still trading in negative territory, according to JPMorgan.
This is buoying demand for debt with ultra-long maturities. Sales of “century bonds” have taken place in Austria, Belgium and Ireland as investors seek extra yield. Companies and institutions, including Oxford University, have also issued bonds that will not mature for 50 or 100 years.
The hunt for higher returns is also luring investors into some of the riskiest countries. A boom in the issuance of emerging market bonds is being partly driven by sales of debt from nations with sub-investment grade, or “junk”, ratings. Last month, junk-rated Nigeria, Kenya and Belarus all tapped international bond markets, taking advantage of soaring demand for higher-yielding debt from so-called frontier markets.
If investors are still willing to plough money into crisis-era US subprime mortgages, exotic frontier debt and long-dated bonds which will not be redeemed until way beyond most investors’ lifetimes, then how much more dangerous and volatile can markets really be?
The fact that investors still have a voracious appetite for risky assets shows that the recent bout of turbulence, although a clear sign that the low-volatility environment of the past two years has come to an end, is not perceived as a regime change for markets.
As I have argued in previous columns, this is mainly because government bonds have yet to come under severe strain despite the beginning of the unwinding of monetary stimulus, led by an increasingly hawkish US Federal Reserve.
The signals from debt markets, particularly over the past few months, suggest that investors believe yields are likely to remain at historically low levels because of subdued inflation and the determination on the part of the major central banks, especially the European Central Bank, to withdraw stimulus in a well-telegraphed and gradual manner.
This presupposes that central banks can unwind their ultra-loose policies in a more or less orderly manner – an assumption fraught with considerable risk, to say the least.
Still, if even tarnished subprime mortgages are in demand, market sentiment must be holding up extremely well.
Nicholas Spiro is a partner at Lauressa Advisory