Janet Yellen, in her testimony in front of Congress yesterday, argued against a stock market bubble. While this is debatable at this point in time, one now must question whether or not there is a bond market bubble taking place underwritten by the Federal Reserve.
We read in the Wall Street Journal "Corporate Bonds Selling at a Record Pace." Mike Cherney writes "Highly rated companies selling bonds in the U. S. at the fastest pace on record, with total bond sales for 2013 surpassing $1 trillion this week, data provider Dealogic said Thursday." He continues "Investors said the deluge highlights worries that interest rates could rise, raising costs for companies, which are diving in now to take advantage of rates that remain low."
Then in the Financial Times we read "Triple C Bond Sales Hit Record High." Vivianne Rodrigues writes "Global borrowers with weaker credit quality are taking advantage of investors' relentless search for higher yield to sell a record amount of bonds so far in 2013." She continues "Bonds with the lowest possible credit ratings have soared in popularity with investors, who have been diverted from top-tier government and corporate debt where central banks are suppressing interest rates."
And then we see the following headline "Corporate Default Risk Models Are Broken." Vivianne Rodrigues and Tracy Alloway write in the Financial Times:
"Even as leverage and signs of credit deterioration build up in the system, most of the models used by investors to forecast the probability of companies not paying back their debt have yet to predict a rise in corporate defaults. Other models, analysts say, have been forecasting a spike in defaults that never materializes.
Concerns are now mounting that the analytical frameworks, which underpin many investment decisions, are becoming increasingly useless when it comes to measuring risks lurking in the corporate bond world and wider financial system."
Furthermore, the article continues, "Ultra-low interest rates and the Federal Reserve's bond-buying program have helped US companies roll over debt obligations in the dollar market at ever lower rates. At the same time, investors who are desperate for returns have little option but to keep buying increasingly weaker-quality debt.
Money has subsequently poured into corporate loans and bonds in recent years, with the result that many companies have been able to increase their borrowing from exuberant markets." And, my concern is that this type of behavior is occurring throughout the financial system.
One area I am particularly worried about is the commercial real estate loan area. I have recently written about this concern. Commercial banks, and not the largest commercial banks, have seen a massive increase in lending on commercial real estate. This was very much a problem area throughout the Great Recession and subsequent recovery. Because these loans are primarily debts that only get paid off at maturity they did not generally get classified as bad loans. As the loans have come due, given the fact that the banks are flush with money supplied them by the Federal Reserve, these loans, similar to the bonds that Rodrigues and Alloway write about, have been "rolled over at lower interest rates" and have even been able to "increase their borrowing" so as to help the borrowers bail themselves out.
I have argued over the past four years that one of the objectives of the Fed's quantitative easing has been to keep as many commercial banks solvent as possible or to keep these banks operating as long as possible so that the FDIC smoothly close them or merge them with more healthy institutions.
Are these examples of a possible credit bubble in the debt area?
Janet Yellen in her testimony responded to questions about the possibility that a bubble exists in the stock market and calmly presented her arguments that she could not see such a bubble at this time. She gave quantitative support to her discussion and did not just dismiss the possibility of bubbles as did Alan Greenspan and Ben Bernanke, her predecessors in the job she is now seeking. She did not address other quantitative measures such as Robert Shiller's CAPE or Shiller's claims that the housing market may again be approaching bubble conditions.
The suggestion has been made that the Fed's quantitative easing has "papered-over" the current "at-the-money" risk in the bond market but, in so doing, has added to "tail risk." Whether or not this has occurred will only be seen, as Warren Buffet has argued in other cases, "when the tide goes out you find out who is not wearing a bathing suit."
Rodrigues and Alloway write "Most credit analysts warn that the outlook for corporate defaults is dependent on the timing of the end of QE, the rise in interest rates and the health of the U.S. economy when the Fed finally decides to scale back."
They then quote Eileen Fahey, chief credit officer at Fitch Ratings: "We expect when interest rates go up there will be an increase in defaults. That's the best we can do." Even if the bond markets are not in a bubble at the present time, many analysts will admit that they are rather "frothy."
The biggest concern is that credit quality in the financial system may not be as high as many government officials would like us to think it is. Also, this leads one to conclude that the efforts of the Federal Reserve have been an attempt to buy us time for the credit problems that still exist in the financial system to work themselves out. If this effort on the part of the Fed has "suppressed" at-the-market credit risk and added to "tail risk" we are just kicking the problems of the economy down the road and are not solving them.
I believe that investors should take a good hard look at this possibility.