Bridge over ocean
1 May 2014 CFA Institute Journal Review

The Big Issue: Are Credit Markets Getting Frothy Again? (Digest Summary)

  1. Richard D. Long

According to one hedge fund manager, the below-investment-grade corporate bond market is approaching a bubble state with high prices and low risk premiums. But positive current economic conditions and the unleveraged position of institutional corporate bond investors may mean that high prices in this market prevail for some time.

What’s Inside?

Seth Klarman, from the hedge fund Baupost Group, has written in a letter to investors that “a skeptic would have to be blind not to see bubbles inflating in junk-bond issuance, credit quality, and yields.” Klarman believes that some securities’ prices have risen “beyond all reason.” One reason behind the increased prices is that investors are buying corporate debt for the higher relative yield. This demand has reduced credit spreads on speculative bonds to levels not seen since 2007.

Increased investor demand has also provided speculative-grade bond issuers with increased flexibility to call or prepay their debt. These call features create a bias to pay off debt early for stronger credits and to keep debt outstanding for weaker credits.

Klarman’s prediction may be right in the long term, but the author does not see imminent warning signs in the credit markets. The bursting of any bubble would require rapidly deteriorating economic and corporate fundamentals or leveraged investors to be forced into selling.

Economic fundamentals continue to be stable as inflation remains low in developed countries and interest rates experience little pressure from central banks. The default rate for speculative bonds is currently 2.9%, down from the long-term average of 4.7%. Credit investors do not appear to be overleveraged.

How Is This Article Useful to Practitioners?

The author points to the potential for an asset bubble in corporate debt, especially in the speculative-grade portion of the market. This information is important for practitioners who do not follow the current supply, demand, and pricing dynamics of the below-investment-grade market. In addition, deteriorating economic fundamentals and overleveraged investors could lead to lower price levels in the speculative-grade bond market.

Abstractor’s Viewpoint

The search for yield continues to skew investment in fixed-income markets. Speculative-grade bonds are attractive for this reason. Refinancing risk is the biggest risk for many of these speculative-grade companies. If demand for these securities decreases, default levels may increase, which could lead to a further reduction in demand and prices. This reduction could ultimately hurt individual investors looking to increase returns by taking more credit risk.

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