The Perfect Storm Is Heading Toward the Debt Market

In the markets, it’s starting to look like the 100-year wave is just over the horizon and I’m left with a sensation that the question is not “if” it is coming but “when.”

For the past couple of years something big has changed in the markets, leaving many market participants feeling like up is down and down up. All of a sudden the bond market is starting to behave more like the stock market, at least in the eyes of the investor. It’s like that moment in the movie The Perfect Storm when Mark Wahlberg and George Clooney decide to weather the storm and the conditions for fishing are almost eerily good. Just like the many oh-so-good years in the bond markets—with some funds having returns well over 100%.

Trying to investigate this new fad in the markets, I’ve talked to many hedge fund managers, researchers, bond traders and other market participants. As the conditions seem to get better and better, it is starting to feel like we might be heading into some kind of never-before-seen storm system.

Perfect storm

For the last few years, the story in the equity markets have developed into a debt story. Most companies have issued new debt, a dramatic increase in debt issuance is expected. Even before 2012 ended, it was clear that the amount of debt issued was at an all time high. As of October, the amount of new debt issued had already reached $306 billion (see chart).

But the debt party, or what later might feel like a hangover, is not over yet.

The magazine Institutional Investor has estimated that European companies need to refinance $8.6 trillion of debt and an additional $1.9 to $ 2.3 trillion of debt for growth by 2016:

“In our view, these factors; the current eurozone crisis, a soft US economic recovery and the prospect of slowing Chinese growth, raise the prospect of a perfect storm for credit markets”

Fed’s worried

It’s not only the issuance that is at a record level, yields, the interest demanded by the market to lend money, is at record low levels. This means that, the so-called “high-yield bonds,” don’t yield very high at all. In the start of 2013, the average yield for a US high-yield bonds, which are sometimes referred to as junk bonds was below 6% for the first time ever.

Recently, US Federal Reserve officials voiced increased concern that the low interest rates would create overheating in many markets—including high yield bonds: “Prices of assets such as bonds, agricultural land, and high-yield and leveraged loans are at historically high levels,” Kansas City Fed President Esther George said in a speech, according to Bloomberg. “We must not ignore the possibility that the low-interest rate policy may be creating incentives that lead to future financial imbalances.”