February 2010

Paper jam

One of the central pillars in the authorities’ policy response to the financial crisis last year was to take interest rates as low as feasibly possible as part of a drive to provide cheap, abundant liquidity. Another key tactic in this regard was “quantitative easing”, whereby money is effectively printed for central banks to purchase assets from cash-strapped institutions and companies. Arguments about their efficacy aside, these initiatives have created an unsustainable liquidity bubble. At some point, central banks will seek to withdraw these facilities (some have already tentatively begun to do this), as they implement their “exit strategies”.

There is currently little consensus in the markets as to the timing of such exits, and expectations change with each economic data release; and, with some national economies weathering the crisis better than others, a concerted exit looks unlikely. Sooner or later, though, interest rates will inevitably rise. In anticipation of this development, governments and corporate borrowers have been rushing to issue new debt securities while rates remain low. In the first ten days of January this year, some $75 billion of new debt world-wide was raised, much of it by capital-hungry financial institutions keen to shore up their still-fragile balance sheets, and the pace of issuance is expected to accelerate as the rate-hike day of reckoning approaches.

Hot, but not toxic

Corporate bonds have enjoyed unprecedented popularity of late, especially among institutional investors, many of whom regard them as a safer bet in the current environment than equities (and even than certain government bonds, due to sovereign debt concerns). Last year, Europe alone saw corporate bond issuance of some $1,340 billion, a 55% increase over 2008. With investor appetite for corporate paper showing no signs of abating, it is little wonder that companies are hurrying to fill their corporate coffers while the cheap-liquidity party lasts.

The credit market rally is expected to come to an end when interest rates begin to rise and drag up fixedincome yields in their wake. Some bond investors are already shifting allocation away from high-quality, investment-grade securities (where yield spreads relative to government bonds have narrowed considerably) into speculative-grade paper (where yields remain attractive enough for those willing to assume the risk of default). In the second week of January, a record $11.7 billion was raised in the high-yield bond market alone. But investment-grade bonds should nevertheless retain their popularity, not least because they will shrink as a percentage of the total fixedincome universe this year due to the upcoming huge issuance of sovereign debt, thus limiting the relative availability of highly-rated paper with yields superior to those of government securities.