Jenga-like structure builds in credit markets
For one influential watcher of the credit world, conditions in the corporate bond market are starting to look unnerving.
Matt Mish, who heads up UBS’s credit strategy team, likens the current state of the market to a tower of Jenga blocks. At the moment, crucial support is being provided by central bank buying across the globe, holding borrowing costs low and providing a backstop if investor demand falls. As that support is removed, piece by piece, the tower could begin to wobble.
“At some point, investors are going to realise that the Jenga puzzle is losing more and more pieces,” said Mr Mish. “It doesn’t mean the tower will definitely collapse but it has the potential to create more volatility.”
Bankers say that, while the topic may not pose an immediate risk, it is beginning to crop up in conversations with clients. How do central banks gently pare their commitment to support credit markets, and what happens if they fall short of it?
“The optimism priced into the market is substantial,” said Mark Lynagh, co-head of European debt markets at BNP Paribas. “It is very much driven by central bank support and an assumption that it will continue in parallel to a successful vaccine rollout. If there is an underwhelming aspect to any of that, it poses a risk to the credit market.”
In the US, the first Jenga block to be taken out came at the end of the year, with the wind-down of the corporate credit facilities that had come to the market’s rescue during the worst of the coronavirus-induced sell-off in March. The US Federal Reserve’s historic decision to begin buying corporate bonds bolstered investor confidence and opened the floodgates to new lending, allowing companies to plug the holes left by the economic downturn with fresh debt.
Despite the facilities’ withdrawal, the tower remains standing, with average yields on both investment-grade and high-yield bonds remaining at or around record lows.
The second support to be removed is expected to be a tapering of the Fed’s purchases of government bonds, to begin as early as this year, according to some predictions. Fed chair Jay Powell said this week that the central bank must be “very careful in communicating about asset purchases” because of the sensitivity among investors about the removal of support for the economy. Whatever the Fed does not buy will need to be bought by other investors and more supply, all else being equal, tends to mean lower prices and higher yields.
When rising Treasury yields are tied to inflation, it is typically no bad thing for corporate bonds. Higher inflation erodes the value of outstanding debt and often indicates higher growth, supporting companies’ ability to repay it. However, rising real yields, which account for any inflationary effects, are an indication of higher borrowing costs for corporates. There have been glimpses of this already this year.
Still, corporate bond markets have largely not flinched. Many…