What Would a Bursting Bond Bubble Look Like?
The corporate bond market faces significantly more risk from rising interest rates than from credit challenges.
As inflation ramps up, many market commentators have questioned whether there will be a bond market crash. The Federal Reserve is fighting inflation by unwinding Covid-era monetary policy. Negative-yielding debt is shrinking as fixed-income investors are positioning themselves for interest-rate hikes and the end of large-scale asset purchases by the central bank.
The timing, pace, and magnitude of future rate increases will be critical in determining whether the potential bond bubble deflates slowly over time or experiences a sudden shock.
Over the past decade, declining bond yields, quantitative easing by central banks around the world, and historically low interest rates combined to fuel rapid growth in corporate debt. When the pandemic came along, it pushed these prevailing market trends to extremes. This may have resulted in the “bond bubble” some envision.
If such a bubble exists, it is vastly more sensitive to interest-rate risk than to credit risk for investment-grade U.S. corporate bonds. If rates rise rapidly, inflation pressures intensify, and fears trigger a selloff in the bond market, investors will experience significant market-value losses. Just a moderate interest rate increase could result in market losses dwarfing credit losses—even if defaults reach highs consistent with a historic stress scenario, which would be much more severe than the credit issues experienced in the pandemic.
The Vicious Cycle of Bond-Fund Liquidity
Mutual funds are a principal vector in the impact of adverse market events, and their role has become even more significant with the growth of the sector in the recent past.
An interest-rate shock would cause mark-to market (MTM) losses in corporate-bond mutual funds, and those losses would pose contagion risks to other asset prices. Investors would react to falling prices—and to forward-looking projections of further declines—by redeeming their holdings. And because funds tend to hold relatively low levels of cash and near-cash instruments, they would be forced to sell into declining markets to meet these redemption requests.
In principle, the funds would attempt to sell vertical slices of their portfolios to maintain their overall liquidity. However, in practice, the most readily realizable securities would likely be sold first. Bond funds might even liquidate more than necessary to meet immediate redemption demand, in order to build up a cash buffer against potential further redemptions. Such an approach could lead to liquidity barbells—portfolios that simultaneously include relatively large cash holdings and a long tail of less-liquid securities. In such a portfolio, every time cash is utilized to meet redemption requests, the asset mix will skew incrementally toward the less-liquid. Material selling could trigger further negative price migration, thus fueling further redemption requests and even lower liquidity among the remaining assets.
The effect would likely be uneven. As investors redeemed cash from corporate bond funds, they would likely redeploy the proceeds into safe-haven assets such as government bonds, gold, or money market funds. The result of the vicious cycle, however, would be to rattle investor sentiment and undercut corporates’ ability to borrow.
Where Are the Market Circuit Breakers?
This vicious cycle could be interrupted in either of two principal ways. First, the Federal Reserve’s support facilities could put a floor on price declines and restore investor confidence. This would reduce redemption requests and enable funds to sell securities into more normalized market conditions. It would be consistent with the interventionist tone of monetary policy since the Great Financial Crisis. But this approach would also represent a further extension of government support, with the long-term distortion effects that brings.
It is worth noting that the Fed’s incentives to act as a “circuit breaker” could be quite different in a rising-rate scenario that is prompted by inflation. The Fed might view anchoring inflation expectations as more important to financial and monetary stability than supporting corporate bond prices. If so, the Fed might take a very different tack this time, compared with the interventionism that markets got used to in the wake of the Great Financial Crisis.
A second potential interrupter of the vicious redemption cycle would be for corporate bond funds to suspend redemptions. Such a move would be possible only with explicit approval of exemptive relief from the U.S. Securities and Exchange Commission (SEC). Such relief has been rare in U.S. markets. The most prominent example was the Third Avenue Focused Credit Fund, which suspended redemptions in December 2015. In contrast, Europe experienced more than 100 fund suspensions in 2020 alone. Although the SEC may not be likely to authorize widespread suspensions, such a scenario would effectively cut redemptions, thus stopping the cycle.
Who Would Feel the Impact of an Interest-Rate Shock?
Although the $6.6 trillion U.S. corporate-bond market would likely incur significant market-value losses in the event of an interest-rate shock, the impact would vary according to the type of investor. Those that are focused on trading and are particularly sensitive to market performance would face greater pressure to sell into falling markets due to concerns around liquidity, leverage, and the regulatory environment. This would especially be the case for leveraged investors such as hedge funds, although their direct holdings account for only a small corner of the U.S. corporate bond market.
Insurance companies. U.S. insurance companies comprise a large segment of the corporate bond market, and they are unlikely to engage in panic selling in an interest-rate shock scenario. Life insurers, in particular, strive to roughly match durations in their bond portfolio to durations of their insurance contract liabilities. This reduces their exposure to interest-rate volatility.
This goal of correlating asset and liability durations enables life insurers to employ buy-and-hold, income-oriented approaches to investment decisions. Thus, they are less likely to need to sell assets during a market downturn.
Other types of insurers may not have the same multidecade investment time horizons as life insurers. Still, their cash and portfolio-liquidity needs tend to be tied more closely to unpredictable, high-severity events than to interest-rate expectations.
Nevertheless, some insurers would face significant risks in a prolonged period of rising interest rates. Insurance companies whose products result in interest-sensitive liabilities, such as fixed-annuity writers, are more susceptible to disintermediation risk than are insurers whose liabilities are tied to protection-oriented products. Furthermore, annuity writers with less-attractive competitive positions, and offering lower-than-peers’ contract-surrender charges, would face a higher risk of policyholders prematurely withdrawing funds when interest rates rise. This could strain their liquidity and capital positions, especially for insurers whose asset durations are meaningfully longer than their liability durations.
Mutual funds. The role of mutual funds as marginal buyers and sellers of risk makes them a key investor segment in corporate bonds. Market losses resulting from an interest-rate shock would be material and would likely trigger redemptions. Where there are liquidity mismatch vulnerabilities, redemptions might amplify the risk of widespread price volatility in the credit markets.
Mutual funds hold relatively little cash, so liquidity would be the main vulnerability if sizable redemptions kicked in following an interest-rate shock. Although high-yield funds typically have materially lower duration than do core bond funds—and so are less directly affected in a rate-shock scenario—they also hold smaller liquidity buffers. This would leave them vulnerable, particularly if contagion effects led to increased redemption pressure.
Non-U.S. investors. The selloff risk from non-U.S. investors would depend, to a large extent, on the investor type. Most foreign investors in U.S. corporate bonds are either insurance companies or mutual funds. Thus, their core investment decisions would be similar to those of the U.S. investor base. However, they would take into account additional considerations, such as exchange rates and currency-hedging costs. There is also the potential for non-U.S. investors to be more flighty than domestic investors in the event of a market shock.
Foreign life insurance companies are big buyers of U.S. investment-grade corporate bonds. Japanese life insurers held more than US$492 billion of foreign securities in July, according to the Life Insurance Association of Japan. The Taiwan Insurance Institute reported that country’s life insurers held around US$690 billion of foreign investments in August, almost 60 percent of their total assets. And, according to the European Insurance and Occupational Pensions Authority (EIOPA), European insurers hold around US$250 billion of U.S. corporate bonds specifically.
Selloff pressure is typically low for foreign life insurance companies, for the same reasons U.S. life insurers adopt buy-and-hold investment strategies. However, non-U.S. insurers that are subject to the Solvency II directive are required to include MTM losses in their solvency-ratio calculations. This is a regulatory requirement that U.S. insurers don’t face, and it might increase the pressure to sell bonds as asset values erode. That said, Solvency II also includes provisions for liability and capital-requirement adjustments that might partially mitigate the MTM losses. Furthermore, if interest rates were to rise moderately and steadily, most insurers globally would benefit, as interest spreads would increase and insurers’ asset and liability durations tend to be matched.
Systemic Risk
Across all these corporate bond investors, an interest-rate shock would create a notable level of risk, even though many have mitigants to resist selloff pressures. A systemwide increase in fixed-income asset pools’ duration exposure, combined with increased levels of outstanding low-coupon debt, have elevated investors’ risk of market-value losses in the event of an accelerated corporate bond selloff. Such losses would be likely if inflation expectations became de-anchored and interest rates rose quickly. This type of shock would also affect other long-duration, fixed-rate securities.
Contagion effects of these pressures might result in a tightening of financing and performance conditions. Added to the increased refinancing risk implicit in a rising-rate environment and a strengthening U.S. dollar, the secondary effects could have negative implications for some corporates’ credit ratings and their ability to borrow.
Thus, every corporate treasury team should be operating through this potential market turning point with an eye toward selloff pressures in the bond market.