WARNING LIGHTS ARE FLASHING IN AMERICA´S CREDIT MARKETS / THE FINANCIAL TIMES COMMENT & ANALYSIS

On Wall Street

August 2, 2013 4:05 pm

 

Warning lights are flashing in America’s credit markets

 

By Stephen Foley

 

much for financial stability hawks to worry about

 

 

Wall Street has played a one-note tune for three months now, focused monomaniacally on the question of when the Federal Reserve will begin to taper its bond purchases. Inevitably, Friday’s disappointing US payrolls numbers were seen giving the Decemberists a boost over the September Songstrels.

 

But while the market has turned on this question since May, it is actually six months since the first hint that the Fed was shifting its thinking on quantitative easing, and that there might be more to the taper question than monthly swings in the economic data.

Fed governor Jeremy Stein’s February 7 speech on “Overheating in Credit Markets” signalled that officials were thinking seriously about the potential financial ill-effects of QE, in a theme that was taken up by chairman Ben Bernanke three months later. It looked an important speech then. It looks seminal now.

 

In it, Prof Stein highlighted the dangers to financial stability as investors reach to earn a little more yield in the ultra-low interest rate environment engineered by the Fed. He ran through a list of indicators where one may spot high-risk practices building up. It is worth repeating the exercise.

The first thing to say is that the months of May and June, when investors got used to the idea that Fed tapering will begin this year, took some of air out of the junk bond and leveraged loan markets – but not nearly as much as one may imagine.

One of Prof Stein’s insights was that policy makers must dig beyond headline numbers such as credit spreads, if they want to see overheating before it is too late. Investors reach for yield by taking on risk in ways that are deliberately harder to measure, by accepting fewer investor protections, for example.

All four of his non-traditional indicators are flashing warning lights, data from Lipper and S&P Capital IQ show. This year’s issuance of payment-in-kind notes, which allow borrowers to put off cash interest payments, is close to passing the total for the whole of 2012, having had the biggest month this year in July.
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Issuance of covenant-lite loans hit an all-time record in February but even through recent turbulence it has remained elevated at monthly levels that were typical in the first half of 2007.

The use of borrowing simply to pay private equity shareholder dividends – “divi recaps” – doubled in the second quarter from the first. July was slow, but there are $8bn of deals slated for August, which will be at least the second-highest month this year.

And finally, the leverage in large buyout deals in July was 5.9 times, the highest since 2007. There is still a wall of money chasing the higher yields from junk bonds and leveraged loans. Leveraged loan funds just recorded their 59th successive week of inflows.

 

There certainly were significant outflows from high-yield bond funds in several weeks when tapering fears were at their height, and Morningstar pegged the total assets in high-yield mutual and exchange traded funds at $340bn at the end of June, down 7 per cent from the end of the previous quarter. But this is still twice as much as six years earlier.

 

The vast expansion of ETFs and mortgage real estate investment trusts has changed financial markets in ways that are yet to be tested. Mortgage Reits in particular, which borrow in short-term markets to fund investments in government-backed mortgage securities, have had a taster of distress. Many have fallen by a quarter in market capitalisation as those securities declined in value since May.

 

Reits’ earnings season is only recently under way but it seems clear that they have been slimming down their portfolios, potentially taking out some of the risks that Professor Stein identified in that sector.

Another risk, though, seems only likely to build. New derivatives trading rules and bank capital requirements are increasing demand for pristine collateral (Treasuries and the like) for short-term lending, but these rules are only now being rolled out by regulators.

 

 

There is much, in other words, for financial stability hawks to worry about, even if the economic doves use the latest payrolls data to argue for a delay to tapering. The evidence from credit markets, and from high-yield and leveraged loan sectors in particular, is that risk-taking may be more widespread even than it was when Prof Stein raised his early warning in February.

 

Copyright The Financial Times Limited 2013.