Could corporate bond prices go into a death spiral? Some recent signs from both central bankers and bond markets suggest such a possibility exists.
With economies recovering in several countries, central banks have signalled that almost a decade of ultra-low interest rates is coming to an end, putting downward pressure on bonds and probably ending their strong performance since the financial crisis of 2008-09. At the same time, capital adequacy rules put in place after that crisis have reduced the liquidity of many corporate bond funds. That has created fears among already nervous bondholders that a selling trend could turn into a rout, with bond prices falling further.
Central banks have had such a meltdown in their sights for months. The Bank of England issued a Financial Stability Paper on July 14, explaining how bond funds pressured by investors might cause a market meltdown. A similar call about the liquidity issue was sounded a month earlier by the Federal Reserve Bank of New York.
The liquidity issue is not new: corporate bonds are often hard to price and harder to trade. The reason is that dealers, which traditionally owned the bonds they traded, no longer carry a lot of corporate bonds in inventory. Now, a corporate bond trade is done on a "best efforts," agency basis for the banks. This widens spreads and adds to bondholders' risk.
Adding a corporate bond fizzle driven by market failure, on top of existing liquidity issues, would be something like the mortgage meltdown of 2008. Banks have been insulated from a repeat performance of that event by a host of new rules that require them to back holdings of corporate bonds, any of which can default, with capital. The banks' balance sheets are stronger as a result, but holders of corporate bonds carry far more trading risk, thus creating a drag on bond markets.
Given this reduction in trading opportunities, anxious bondholders may rush to the head of the line when pressure to sell begins rising. Making matters worse, rising interest rates will put pressure on bond prices, especially those of heavily indebted large issuers such as utilities. That could be the trigger for a bond market meltdown.
Under great duress, the corporate bond market could even lock up, says Edward Jong, vice president, fixed-income, with TriDelta Investment Counsel Inc. in Toronto. In such a scenario, there would be no prices, no trades and nowhere to shift risk.
"There could be a fire sale, but buyers ought to come in if issues with solid AA ratings rise to 4% or 5% from a recent 1.84%. Then, we would step in," says Vivek Verma, vice president at bond investment specialist Canso Investment Counsel Ltd. in Richmond Hill, Ont. "You are compensated by the yield at purchase. Most institutions would have small weightings. You could wait to sell."
That's the theory. The reality is different. On Feb. 23, 2016, Canadian Natural Resources Ltd.'s (CNR) U.S. dollar-denominated 3.8% issue, due April 2024, spiked to yield 8.49% to maturity, which was 669 basis points (bps) over the U.S. treasury bond that paid 1.8% on that day.
"It was rare for a well-known name to go begging. But, on that date, all energy bonds were selling off. It looked like a fire sale," recalls Chris Kresic, partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto.
The bond was in trouble because oil prices had sagged below US$30 that day, he adds. The consensus was that selling oil bonds was a good strategy; the bond's price reflected that. The issue's yield then tumbled in following weeks to 3.55% at the beginning of August, as oil prices and bond market confidence recovered.
There are other risks that could lead to a bonds fire sale. A great deal of corporate debt was issued during the period of low interest rates, if only to finance equity buybacks, Kresic explains. That boosted leverage.
Other factors: the investment community buying a lot of debt; and so much of the retail community has bought passive debt through index funds.
"When bonds are in index funds, which have blossomed to hold massive amounts of debt, it is the general mood rather than bond quality or price that moves the market," Kresic explains.
Is the bond market pricing in the correct liquidity risk now, Kresic asks. Investment-grade spreads were as tight as 50 bps over governments of the same term before the financial crisis.
Now, investors should demand premiums of more than 50 bps - perhaps 100 bps, which includes the potential fire sale - for taking on liquidity risk. Also, compared with 10 years ago, credit quality is weaker, so investment-grade bonds outstanding tend to be one notch lower than in 2008.
For passive bondholders, risks may include remaining uncompensated for lower quality and lower returns.
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