Behind the rally in global debt markets lurks a disaster just waiting to happen. At least, that’s what some long-time market watchers are warning.
While dovish comments by the Federal Reserve and other central banks have prompted investors to pile back into bonds, two troubling developments could make buyers uniquely vulnerable to deep and painful losses, they say. One is the sheer amount of ultra-low yielding debt, which means investors have almost no buffer in the event prices drop. That’s compounded by the worry liquidity will suddenly evaporate in a selloff and leave holders stuck with losses on positions they can’t get out of quickly.
Granted, nobody is actually predicting when things will turn ugly in the bond market, and history hasn’t been particularly kind to the doomsayers. Still, the risk is real, they say, and caution is more than justified. By one measure, the amount of investment-grade bonds has doubled to $52 trillion since the financial crisis. And yields have, on average, fallen to roughly 1.8 percent, less than half the level in 2007. If they were to rise by a mere half-percentage point, investors could be looking at almost $2 trillion in losses.
“This is an element of hidden leverage that is not appreciated,” says Jeffrey Snider, global head of research at Alhambra Investments. “We are eventually going to have a shock.”
The current situation is a legacy of the easy-money polices enacted by central banks following the financial crisis. With interest rates at or near zero, governments and corporations went on a historic borrowing binge — and investors gorged on debt that yielded little in return. What’s more, rules to strengthen financial firms and curb their risk-taking meant the big banks now played a much smaller role as intermediaries, transferring more of the risk of getting in and out of trades onto investors.
These worries aren’t new, of course, but they’ve attracted fresh attention as the amount of negative-yielding debt has climbed past $10 trillion. To some, it’s a sign investors have gotten a little too complacent and could easily get blindsided once growth and inflation start to pick up.
One way to assess just how much risk has been built into the bond market is by looking at something called duration. Simply put, it measures how much the price of a bond moves relative to a move in its yield.
Currently, the duration of $52 trillion of investment-grade bonds tracked by Bloomberg globally stands at about 7, close to a record high. (Bonds with low yields and long maturity dates tend to have the highest duration.) That means if yields rose a full-percentage point, the bonds would lose 7 percent of their market value. For a half-percentage point jump, that works out to 3.5 percent, or a $1.8 trillion loss.
“The debt load in the world is so high now that it can’t withstand any historically-normal size of interest rate increases anymore,” says Stephen Jen, chief executive officer of Eurizon SLJ Capital.
The risk of getting left behind when everyone heads for the exits is something Elaine Stokes takes to heart. The Loomis Sayles money manager says when she screens for securities to buy, the ability to get out of the trade is a key factor. That concern was underscored by JPMorgan Chase’s Jamie Dimon, who wrote in his annual shareholder letter that investors face a “new normal” of reduced liquidity and heightened volatility because of tighter regulations.