Moonwalking bears and underwater bergs: hidden risks in markets Alex - - PowerPoint PPT Presentation

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

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.

Components of yield on US-dollar investment-grade corporate bond index

1 2 3 4 5 6 7 8 9 10 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 Per cent

Risk-free interest rate Term premium + credit spread Yield

…Very unusual in a US monetary policy tightening phase

Sources: ICE Bank of America Merrill Lynch and Bank calculations.

Cumulative changes in US-dollar investment-grade corporate bond yields

• 2
• 1

1 2 3 1 2 Per cent Years since first increase in federal funds rate 1994 1999 1988 2004 Current

Price of default insurance fallen… …but risk of default hasn’t

20 40 60 80 100 120 March 2016 January 2018

Default probability (basis points) Density

50 100 150 200 250 300 350 400 March 2016 January 2018

CDS premium (basis points) Density

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.

Distribution of CDS premia Distribution of default probabilities

Little compensation for risk in £ corporate bonds

Components of yield on adjusted sterling investment-grade corporate bond index

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

• ver 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.

1 2 3 4 5 6 7 8 9 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18

Per cent Risk-free interest rate Term premium + credit spread Yield

Something more than QE at work...

Components of yield on adjusted sterling investment-grade corporate bond index

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

• ver 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.

QE announcement dates No QE in effect

1 2 3 4 5 6 7 8 9 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 Per cent

QE1 QE2

Risk-free interest rate Term premium + credit spread Yield

QE3 QE4/CBP

A search for yield? Past performance used as guide to future?

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.

Total return since March 2009 Investment-grade corporate bonds

106%

Gilts

59%

High-yield corporate bonds

382%

Cash

4%

Record issuance of riskier types of corporate debt recently

Sources: S&P Global Market Intelligence and Bank Calculations. Note: Issuance is shown on a gross basis.

Issuance of high-yield bonds and leveraged loans by UK private non-financial corporations

5 10 15 20 25 30 35 40 06 07 08 09 10 11 12 13 14 15 16 17 18 First Quarter Remainder of year Refinancing value £ Billions

In 2008, built up of excessive leverage via derivatives = firesales

AIG builds up leverage through $400bn of CDS on MBS MBS credit quality declines AIG credit rating downgraded Margin call Firesales? US Government support

Need for diagnostic tools I: collateral calls

Liquid assets to meet the call Collateral call

In 2008, a run on money market funds. Now reformed.

First-mover advantage

Lehman defaults Primary Reserve Fund ‘breaks the buck’ Run on US prime MMFs and fire-sales Commercial paper market shuts MMF structural reforms

2014: US institutional money funds become variable NAV. 2017: ‘Low-volatility’ NAV funds introduced in Europe.

:

Increasing share of corporate bonds held in open-ended funds

Funds’ holdings of corporate bonds

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.

5 10 15 20 25 30 2008 2017 United Kingdom (sterling-focused corporate bond funds) United States (corporate and foreign bonds held in the United States) Euro Area (PNFCs)

Percentage of total

Open-ended funds are much safer. But could there be a more subtle first-redeemer advantage?

Sources: Morningstar and Bank calculations. Note: These estimates are for European-domiciled open-ended funds, excluding ETFs, MMFs and funds of funds.

Fund redemptions following 1% fall in asset value

0.1 0.2 0.3 0.4 0.5 0.6 0.7

Equity Commodities Mixed (equity/fixed income) Government bond Corporate bond Per cent of assets Redemptions as percentage of total assets following 1% loss

At same time, dealers have become less active in market making

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. Response of US high-yield corporate bond dealer inventories and spreads to a negative demand shock (i.e. sales) from asset managers

Dealers’ response to high-yield bond sales

2 4 6 8 10 12 14 16 18 20 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 Pre-crisis Post-crisis

Basis points of market size Basis points Inventory Spread

Need for diagnostic tools II: System simulations

Redemptions from funds Amplification of market shock Reduction in market-making capacity Forced asset sales Market shock

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)