High Yield Bonds: Yellen Yells Out Over Exuberance

Risk of corporate defaults severely underestimated by the market

by Ron D’Vari, & James Frischling, President, NewOak

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U.S. Federal Reserve Chairwoman Janet Yellen warned investors last week of over exuberance and blamed them of counting too much on accommodative central bank policies. With high yield corporate bonds’ yields less than 5%, monetary policy makers think the risk of corporate defaults are severely underestimated by the market.

Paradoxically, the low volatility environment created by the U.S. and European central banks encouraged investors to reach for yield and higher leverage hence ignoring potential risks. The concern is that volatility will spike up at the first sign of any rise in rates, causing another wide spread credit crisis threatening the financial system.

Yellen emphasized that monetary policy’s primary goal is to address the issues of under employment and disinflation. As the first line of defense, the overall financial stability matters are addressed through macro-prudential regulatory bodies and policies and not through monetary policy.

Regulators across the globe have been pursuing much stricter macro-prudential policies to reduce interconnectivity among systemically important financial institutions (“SIFIs”) and strengthen the architecture of the global financial systems. These efforts have led to requirements for more capital with higher quality, larger liquidity buffers, central clearing of derivatives as well as monitoring of the tri-party repo operations for banks and SIFIs.

The regulatory boundaries only go so far and do not cover non-bank non-SIFI sector. To meet their portfolio yield targets, non-bank non-SIFI entities (typically alternative investors) have been pouring money into the high yield corporate sector and increasing leverage. Regulators fear that at some point this could impact the financial stability they are working hard to protect and as a result are carefully monitoring credit standards and leverage.

... the low volatility environment created by the U.S. and European central banks encouraged investors to reach for yield and higher leverage hence ignoring potential risks

This has risen to a level to require regulators to take any special action. Given today’s robust banking system and relatively tight housing and consumer credit environment in general, it will be a while before these concerns will take center stage.

Regulations & Unintended Consequences

Regulatory changes have both intended and unintended consequences. For example, Sarbanes-Oxley, which is often deemed to be the most important piece of security legislation since the Securities and Exchange Act of 1934 had the intended consequence of bringing more transparency to both markets and corporate governance by requiring public companies to obtain an independent audit of their internal controls. An unintended consequence of Sarbanes-Oxley was that it increased the cost of being a publicly traded company and resulted in some firms choosing to stay or go private. The Act proved to be a win for private equity firms and dramatically increased the amount of money they managed.

Dodd-Frank represents the greatest regulatory change since Sarbanes-Oxley and once again it’s creating consequences that are benefitting private equity firms. With banks feeling the brunt of the regulatory changes as a result of the financial crisis, one of the consequences is that as banks divest – or at least reduce risky activities – private equity firms are stepping in to take their place. Private equity firms have successfully raised mountains of capital to replace the proprietary books that once dominated Wall Street.

Another consequence is that human capital is following the money. The New York Times wrote a story about how young bankers are being recruited by private equity firms from the Wall Street banks at a feverish pace. Buying distressed assets as banks are forced to shed risk is only one segment of the market where private equity firms increased their presence. Low interest rates and a strong stock market have increased the demand for banking talent as private equity firms seek to purchase more companies.

As regulations reduce the risk-taking activities at Wall Street banks, private equity firms are expanding their footprint. Come to think of it, maybe these consequences aren’t unintended at all and in fact maybe the commoditization of Wall Street is the intended consequence.