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In a series of speeches, Federal Reserve Governor Jeremy Stein emphasized the importance of financial stability concerns in monetary policy-making. But how does one measure whether threats to financial stability are lurking?

Put differently, can we know that there is a credit bubble about to burst?

In his speeches, Stein cites the work of two Harvard Business School professors, Robin Greenwood and Samuel Hanson. Their research argues that a good indicator of credit market overheating is the share of all new corporate debt issues coming from low-grade issuers.

This measure is based on the quantity of credit issued, not just interest rates. Others focus exclusively on credit spreads, or the interest rate differentials between, say, junk and investment grade firms. Greenwood and Hanson argue that quantities of credit issued by low-grade versus high-grade firms add a lot of power when predicting credit market crashes.

So how big is the risk of a credit market crash today? Robin and Sam were nice enough to send us the updated data through 2013. This chart shows the high yield share of corporate debt issues. Or in other words, the fraction of all corporate debt issues by high yield (or junk) firms:

(click to enlarge)

You can see right away that this variable predicts crashes pretty well. The high yield issue share peaks about two years before major meltdowns we’ve seen in credit markets. So when risky firms are issuing a ton of debt, bad things tend to happen.

The high yield share in 2012 and 2013 indicates elevated risk, but not an impending disaster. For example, the 2013 high yield share is still below the peaks seen prior to other credit crashes. This may be driven in part by the fact that investment grade firms are also issuing a ton of debt. So in some sense the denominator is rising so fast that the high yield bond issues cannot keep up with it.

As mentioned above, another measure people use to predict credit market overheating is the interest spread between Baa rated-debt and Aaa rated-debt. If this spread narrows, then credit markets are willing to fund riskier firms at lower interest rates. Here is the chart showing this spread:

(click to enlarge)

Looking at the long history, you can see why interest spreads don’t do as good a job predicting crashes as the high yield share. The interest spread falls before every crash, but the pattern is not nearly as stark as it is with the high yield share of debt issues above.

As this chart shows, the interest spread has fallen substantially in 2012 and 2013, but remains slightly above the very low levels it reached before the 2001 recession and the Great Recession.

Greenwood and Hanson put both of these variables into a simple regression framework to predict excess returns on risky bonds over the next two years. They can use the historical data to estimate the model, and then they can show the predicted return on risky bonds over the next two years. Here is the graph of the predicted excess return on risky bonds:

(click to enlarge)

This is the picture that worries many. The Greenwood-Hanson model is currently predicting negative excess returns on risky bonds. That is the definition of a bubble — people are buying risky bonds that in expectation will deliver less return than riskless bonds. As you can see, their model predicts negative excess returns prior to the Great Recession as well. This is the exact same graph that Governor Stein showed in one of his speeches (see his Figure 1 left panel).

Gene Fama is right that predicting bubbles is near impossible. The methodology of Greenwood and Hanson is based on a pretty small sample, and we cannot be sure that it will work out of sample. Further, their measure predicted low returns in 2010, but returns over the next two years were strong. At the very least, their model should lead to some worries. And it also tells us that the financial stability concerns of Governor Stein and others are based on something more than just instinct.

Disclosure: No positions

Source: Are We Headed For A Credit Market Crash?