Rising government bond yields have sparked fears that a bubble in corporate bonds could burst soon. US Treasury yields rose following the news of Republican Donald Trump’s surprise victory in the US election, as investors anticipated the potential inflationary effects of his plans for large-scale infrastructure projects.
If everyone heads for the exit at the same time, there is no way liquidity will be met
Over the past three months, gilt yields have increased by almost 60 basis points, while Bunds and Treasuries are up by over 20 basis points due to improving economic data. There is an inverse relationship between bond prices and yields, which means that if prices fall it causes yields to rise.
In the UK, consumer price inflation rose to 1% in September, which also contributed to the sell-off in gilts. Many expect inflation will continue to increase, as a weaker pound following the Brexit vote creates higher import costs. Inflation represents an enemy of bonds because you lock into a fixed income when you buy a bond, which can be eroded by high inflation. High inflation therefore makes bonds less attractive to hold.
If yields continue to rise, could this spark a sell-off in corporate bonds? Pantheon Macroeconomics’ analyst Claus Vistesen suggests so. In his opinion, a number of factors that have kept yields at low levels in the US are starting to reverse. For example, rising inflation and wage, alongside nominal GDP.
In an environment of low government bond yields over the past few years, investors have looked elsewhere for attractive yields, not least in corporate bonds. Vistesen is concerned that this shift will create problems.
“Yield-hungry investors have piled into corporate debt, ignoring liquidity risks, and the fundamentals of the firms issuing the debt,” he warned.
Liquidity Crunch
This situation could become dangerous if there is a significant sell-off in corporate bonds and this, in turn, causes liquidity to dry up. The recent run of property fund suspensions highlight how quickly funds can run into problems when the underlying asset class comes under pressure, causing investors to lose confidence and withdraw their money. If too many investors run for the door at the same point, it becomes hard for fund management groups to provide daily dealing to investors.
“The mismatch between the promise of daily liquidity in funds and the illiquidity of their underlying assets is a toxic combination if yields rise suddenly,” Vistesen added.
The issue is certainly on the agenda for regulators around the world and has been highlighted by the International Monetary Fund. Andrew Wilson, head of invest at Towry, also has concerns about liquidity in corporate bond markets.
“There is no way that if everyone heads for the exit at the same time, liquidity will be met. The risk is no different than it was six or 18 months ago for corporate bonds. It is the same with property funds. With anything you own, you need to be aware how long you are prepared to own it for. Only the most liquid financial assets can be sold at the worst moments,” Wilson explained.
“There is only one way that things that are overbought - and arguably overvalued - can go. And you never get the same liquidity on the way down as you do on the way up.”
As regulation concerning the market-making roles of banks has reduced their involvement in the corporate bond market, Wilson suggests that if sentiment turns negative those looking to sell may struggle to find someone who is willing to pay the price they are looking for.
In his opinion, rising gilt yields are unlikely to spark a liquidity crunch in corporate bond markets. He suspects the factor that leads to a significant sell-off will be “entirely psychological”.
“It will be the same as when the Standard Life UK Real Estate fund suspended trading, which caused a stampede out of other property funds. There will be a psychological point, which is impossible to forecast in advance. It could be a small thing but it will be enough to cause a tipping point and a psychological cascade effect,” he said.
Adrian Hull, a fixed income specialist at Kames Capital, does not agree that liquidity in corporate bond markets will prove to be a significant problem, even if banks are no longer buyers in the market.
“I get slightly worried that the script is, ‘expensive bonds, equals everyone sells at once, equals a valuation and liquidity gap’. There have been huge moves in government bonds already and the market has behaved reasonably,” he noted.
Hull thinks it is unfair to link what has happened to property funds to bond funds, given that investment grade is a transparent and actively traded market that has already survived some testing times. It does not share the same liquidity profile as property.
“You might not like the price, but there will be a price and you can still trade,” he added.
Should Investors Be Worried?
Jim Cielinski, Columbia Threadneedle’s global head of fixed income sums up the situation well.
“A final important lesson of bubbles is that they tend to end badly, but also that they end quite differently, and very often through unexpected channels. Timing the exit is always difficult. It is important to recognise today, however, that irrespective of whether or not the bubble is about to burst, the good times are over,” he said.
