Moonwalking bears and underwater bergs: hidden risks in markets Alex Brazier Executive Director for Financial Stability Strategy & Risk, Bank of England 26 April 2018 London Business School Asset Management Conference 2018
Two types of hidden risk in markets Bears: in plain sight Bergs: in the system Did you see the moonwalking bear?
Little compensation for risk in global corporate debt markets Components of yield on US-dollar investment-grade corporate bond index Risk-free interest rate Per cent Term premium + credit spread 10 Yield 9 8 7 6 5 4 3 2 1 0 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 Sources: ICE Bank of America Merrill Lynch, Federal Reserve Bank of New York and Bank calculations. Note: The chart shows how the yield on an index of US-dollar investment-grade corporate bonds (in orange) splits into two components. The first component (in blue) is the risk-free interest rate, which reflects expected Federal Funds rates over a period equal to the (7-year) duration of the index. The second component (in purple) is the difference between the yield and the first component, and reflects the term premium and credit spread.
…Very unusual in a US monetary policy tightening phase Cumulative changes in US-dollar investment-grade corporate bond yields Per cent 3 2 1994 2004 1999 1 1988 0 Current -1 -2 0 1 2 Years since first increase in federal funds rate Sources: ICE Bank of America Merrill Lynch and Bank calculations.
Price of default insurance fallen … … but risk of default hasn’t Distribution of CDS premia Distribution of default probabilities Density Density March 2016 March 2016 January 2018 January 2018 0 50 100 150 200 250 300 350 400 0 20 40 60 80 100 120 CDS premium (basis points) Default probability (basis points) Sources: Bloomberg, Credit Benchmark and Bank calculations. Note: The charts show fitted densities of CDS premia and default probability estimates for corporate debts referenced in the current CDX.NA.IG credit default swap index. The CDS premia are annual amounts on five-year senior CDS contracts and the default probabilities are aggregates of one-year ahead estimates constructed by financial institutions following an internal-ratings-based approach to regulation.
Little compensation for risk in £ corporate bonds Components of yield on adjusted sterling investment-grade corporate bond index Risk-free interest rate Per cent Term premium + credit spread 9 Yield 8 7 6 5 4 3 2 1 0 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 Sources: ICE BofAML, Bloomberg, HMT and Bank calculations. Note: The chart shows GBP investment-grade corporate bond yield and the expected risk free rate (based on a maturity (7 years) that is similar to the duration of the corporate bond index over the period shown). The difference between the corporate bond yield and the expected rate is the term premium plus the credit spread. The adjusted sterling investment-grade spread accounts for changes in credit quality and duration of the index over time.
Something more than QE at work... Components of yield on adjusted sterling investment-grade corporate bond index Risk-free interest rate Per cent QE1 QE2 QE3 QE4/CBP Term premium + credit spread 9 QE announcement 8 Yield dates 7 6 5 4 No QE in effect 3 2 1 0 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 Sources: ICE BofAML, Bloomberg, HMT and Bank calculations. Note: The chart shows GBP investment-grade corporate bond yield and the expected risk free rate (based on a maturity (7 years) that is similar to the duration of the corporate bond index over the period shown). The difference between the corporate bond yield and the expected rate is the term premium plus the credit spread. The adjusted sterling investment-grade spread accounts for changes in credit quality and duration of the index over time.
A search for yield? Past performance used as guide to future? Total return since March 2009 Investment-grade High-yield corporate bonds corporate bonds 106% 382% Gilts Cash 59% 4% Sources: ICE Bank of America Merrill Lynch, Bank of England and Bank calculations. Note: Change is calculated between 02/03/2009 and 31/03/2018.
Record issuance of riskier types of corporate debt recently Issuance of high-yield bonds and leveraged loans by UK private non-financial corporations £ Billions First Quarter Remainder of year 40 35 Refinancing value 30 25 20 15 10 5 0 06 07 08 09 10 11 12 13 14 15 16 17 18 Sources: S&P Global Market Intelligence and Bank Calculations. Note: Issuance is shown on a gross basis.
In 2008, built up of excessive leverage via derivatives = firesales AIG builds up leverage through $400bn of CDS on MBS AIG credit MBS credit rating quality declines downgraded Margin call US Government Firesales? support
Need for diagnostic tools I: collateral calls Liquid assets to Collateral call meet the call
In 2008, a run on money market funds. Now reformed. Lehman defaults Primary Reserve Fund First-mover ‘breaks the buck’ advantage Run on US prime MMFs and fire-sales Commercial paper market shuts 2014 : US institutional money funds become variable NAV. MMF structural 2017: ‘Low - volatility’ NAV funds reforms introduced in Europe. :
Increasing share of corporate bonds held in open-ended funds Funds’ holdings of corporate bonds United Kingdom (sterling-focused corporate bond funds) Percentage of total United States (corporate and foreign bonds held in the United States) 30 Euro Area (PNFCs) 25 20 15 10 5 0 2008 2017 Sources: Bank of England, Thomson One, ECB, Federal Reserve, Morningstar and Bank calculations. Note: United Kingdom: sterling corporate bond funds (open-ended and ETFs) total net assets as a share of all outstanding sterling corporate bonds. United States: mutual funds' holdings of corporate and foreign bonds as a share of all outstanding corporate and foreign bonds. Euro Area: euro-area open-ended holdings of bonds issued by euro-area non-financial corporations as a share of total. United Kingdom data until July 2017. United States data until Q1 2017. Euro Area data until Q2 2017.
Open-ended funds are much safer. But could there be a more subtle first-redeemer advantage? Fund redemptions following 1% fall in asset value Per cent of assets Redemptions as percentage of total assets 0.7 following 1% loss 0.6 0.5 0.4 0.3 0.2 0.1 0 Equity Commodities Mixed (equity/fixed Government bond Corporate bond income) Sources: Morningstar and Bank calculations. Note: These estimates are for European-domiciled open-ended funds, excluding ETFs, MMFs and funds of funds.
At same time, dealers have become less active in market making Dealers’ response to high -yield bond sales Basis points of Basis points Pre-crisis Post-crisis market size 1.6 20 Response of US high-yield corporate 18 1.4 bond dealer inventories and spreads to 16 a negative demand shock (i.e. sales) 1.2 from asset managers 14 1 12 0.8 10 8 0.6 6 0.4 4 0.2 2 0 0 Inventory Spread Sources: BofA Merrill Lynch Global Research, Dealogic, EPFR Global, Federal Reserve Bank of New York, SIFMA and Bank calculations. Note: Response (at 1 week) of US dollar-denominated high- yield corporate bond spreads and US primary dealers’ inventory in these securities to a one standard deviation decline in asset manager demand (of the pre-crisis period). Based on the SVAR model. Pre-crisis refers to 2004-2006, post-crisis refers to 2012 - February 2015.
Need for diagnostic tools II: System simulations Redemptions Forced asset Market shock from funds sales Reduction in Amplification of market-making market shock capacity Baranova, Y., et al. (2017), ‘Simulating stress across the financial system: the resilience of corporate bond markets and the role of investment funds’, Bank of England Financial Stability Paper, no. 42, (July)
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