In recent weeks, significant attention has been paid to the possibility of a stock market correction. By contrast, few have focused on the challenges developing in the corporate bond market.
The bond market is as important to the economy as the stock market. Remember that the Great Recession was triggered by a meltdown in the mortgage market. And the domestic debt market — some $41 trillion — is much larger than the domestic stock market, at $30 trillion.
So the corporate bond market is important. Why is it vulnerable?
The primary cause of the problems in the U.S. corporate bond market has been the ultra-low interest rates that have prevailed since 2008. The liquidity boom ushered in by programs such as quantitative easing has encouraged “yield-chasing” that has caused bond prices to increase beyond their intrinsic value.
Under this Fed policy of introducing new money into the economy to counter the recession, the Fed’s balance sheet expanded to about $4.5 trillion from less than $900 billion before the crisis. The Fed also cut interest rates to near zero. The resulting low interest rates encouraged U.S. public corporations to borrow heavily in the bond market. According to the St. Louis Federal Reserve, non-financial corporate debt has increased by more than $2.5 trillion, or 40 percent, since 2008.
U.S. corporate debt is currently at a historic high, some 45 percent of gross domestic product.
In a July 30 interview on CNBC, Jamie Dimon, the chairman and chief executive of JPMorgan Chase, said the biggest risks to the economy were the implications for bond prices and credit markets generally of tariffs placed on Chinese goods and the unwinding of the Fed’s quantitative easing policies by reducing its assets, limiting reinvestment in bonds when older ones mature.
“I don’t want to scare the public,” he said, “but we’ve never had QE. We’ve never had the reversal.”
The Federal Reserve also has begun raising interest rates toward levels close to historical norms. In cost of money has risen sharply. UBS estimates that we have a record of $4.3 trillion in lower-quality corporate loans and high-yield bonds. The ability to repay this debt will be impaired if the economy wobbles and corporations’ earnings decline.
The prices of bonds (and corporate loans) do not accurately reflect the riskiness of the underlying borrower’s credit. So-called “junk bonds” issued by companies with poor credit ratings historically have yielded around 10 percent or more to compensate investors for taking the risk of buying them. Currently, because bond prices go the opposite way from their yields, junk bonds yield only around 6.25 percent. At these levels, these bonds fail to compensate bondholders for the risks they are taking.
When junk-bond yields return to more normal levels, the price of the bonds bought during this frenetic period will decline precipitously, and billions of dollars will be lost.
I agree with the sentiments of the International Monetary Fund. “When the economy is doing well and everybody seems to be making money,” it posted in a blog, “some investors assume that the good times will never end. They take on more risk than they can reasonably expect to handle.”
Rising interest rates will put enormous pressure on weaker corporate credit, leading to defaults. If this happens, most borrowers’ access to credit could dry up, setting off a financial economic crisis.
While we need to be mindful of the excesses in the corporate bond market, corporations currently are having no problems meeting their debt obligations. Earnings of the S&P 500 companies rose some 25 percent in the second quarter.
This rosy scenario could end, however, if we impose 25 percent trade tariffs on all imports from China and if our worker shortage also hampers growth. If corporate profits stagnate and interest rates continue to rise, we then need to pay more attention to the corporate bond market, especially the high-yield market.
Originally published in the Sarasota Herald-Tribune
