A Bubble in Bonds?

by Marilou Long on May 13, 2014

in Bonds,Debt,Economic Indicators,Fed policy,Fixed Income,interest rates

The S&P 500 hit 1900 for the first time today, but it is the bond market that the Financial Stability Oversight Council is concerned about.  From the 5/12/14 Yardeni Research Morning Briefing:

Coincidently, the Financial Stability Oversight Council (FSOC) issued its annual report last Wednesday. While Yellen was reassuring about bubbles, the report was much less so. The Council was established by the Dodd-Frank Act and is charged with the job of identifying “risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or nonbank financial companies, or that could arise outside the financial services marketplace.”

The Council is expected to respond “to emerging threats to the stability of the U.S. financial system.” It consists of ten voting members and five nonvoting members and brings together the expertise of federal financial regulators, state regulators, and an insurance expert appointed by the President. Fed Chair Janet Yellen is a voting member and signed off on the report, which included the following unsettling warning:

“The prolonged period of low interest rates has led investors to extend maturities, purchase lower quality credit, and increase leverage in a search for yield. As a result, higher-yielding strategies have experienced substantial inflows of funds. Financial institutions also have responded to the low interest rate environment. Banks have eased loan underwriting standards, while insurance companies and MMFs have moderately increased the duration of their portfolios. Although interest rates have risen from historic lows, rates could rise further and impose losses for the holders of fixed income assets. Additionally, since the majority of leveraged lending is floating rate and borrowers are highly leveraged, a sharp increase in interest rates could increase the risk of default of these borrowers and impose costs on their lenders. Of course, a continued low rate environment also has risks. It continues to weigh on earnings of banks, insurance companies, pension funds, and retirement funds, putting further pressure on them to pursue riskier investments in order to meet their targeted returns.” 

The spread of junk bond yields to treasuries remains very tight, and while this bodes well for the outlook for economic growth, it illustrates the risks of reaching for yield that is mentioned above.

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