A Stein in Bernanke’s shoe: Is there a bubble in corporate bonds?

February 25, 2013

Financial markets are again on edge about the direction of Fed policy following the surprisingly hawkish minutes of the January meeting released last week, even if most still expect the central bank to keep buying bonds at the current $85 billion monthly pace at least until the end of the year.

Federal Reserve Board Governor Jeremy Stein, an academic economist who joined the central bank last May, surprised Fed-watchers in his latest speech by focusing entirely on the risks of recent monetary stimulus and saying very little about its benefits. In particular, Stein, a corporate finance expert, raised the possibility that a bubble might be forming in the corporate bond markets, which has seen yields fall to record lows and issuance to record highs.

While the speech was riddled with caveats, Wall Street took it as an unusually stern warning about the potential side effects of quantitative easing from Fed’s inner-sanctum, the influential, presidentially-appointed Board of Governors in Washington. Stein argued:

Putting it all together, my reading of the evidence is that we are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit. However, even if this conjecture is correct, and even if it does not bode well for the expected returns to junk bond and leveraged-loan investors, it need not follow that this risk-taking has ominous systemic implications. That is, even if at some point junk bond investors suffer losses, without spillovers to other parts of the system, these losses may be confined and therefore less of a policy concern.

His position should not be overstated: just in December Stein strongly backed QE3.

Jan Hatzius and his team of economists at Goldman Sachs say there is no cause for alarm despite the tightening of credit spreads and brisk corporate bond issuance.

The metrics (Stein) identified are certainly worth watching. But at this point, we do not believe that credit market overheating – and the risk of another downturn in this area–is a large risk to the US economic outlook.

First, private-sector asset valuations – equities, credit, and housing – do not look particularly challenging. Government bond valuations are undoubtedly high, but we see good reasons why they should normalize only gradually, not least the Fed’s ability to intervene if needed. A more substantial asset price downturn is of course possible, given the inherent uncertainty about what the future might hold. But the probability of such a downturn does not look unusually elevated to us.

Second, leverage in the financial system has diminished sharply since 2007. This means that the risk of “leveraged losses” – our term for a situation in which a given loss has a multiplied negative impact on lending and economic activity as leveraged institutions retrench sharply – also looks much smaller than it did a few years ago, even if asset prices were to decline more substantially.

Third, credit growth has remained very subdued in recent years, even after the end of the crisis. Although credit market activity has picked up more recently, we believe we are still quite far from any sort of generalized credit boom that might foreshadow another bust.

Fourth, the overall economy is not particularly dependent on private sector credit. Unlike in the 1997-2007 period, when the private sector ran a large financial deficit that had to be covered by net borrowing, households and businesses are currently still running an unusually large financial surplus.

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