The Bond Market

Interest Rate Risk Outweighs Credit Risk From Potential Bond Bubble

Still, impact of a ‘bond shock’ remains low

New market research from Fitch examines investor and market sensitivity to rising rates. Read more here.

Fitch Ratings-London/Brisbane/New York-18 November 2021 — Investors face higher potential market-value losses than credit losses in the event of an accelerated U.S. corporate bond sell-off, due to the system-wide increase in fixed income asset duration and higher levels of low-coupon debt, Fitch Ratings says. However, the direct ratings impact of a bond shock for Fitch-rated insurance companies, pension funds, short-term funds and banks is generally low given mitigating factors such as liquidity risk management and regulatory treatment of mark-to-market losses.

Contagion effects of a bond sell-off could, nonetheless, tighten financing and performance conditions, which would have greater implications for credit ratings. Increased market volatility and decreased liquidity could cause investors to de-risk and rotate strategies, putting further pressure on market prices.

The low interest rate environment has changed the risk profile of the corporate bond market, increasing the possibility of a bond market bubble. This could result in significant market-value losses in an interest rate shock scenario if inflation expectations become de-anchored and interest rates rise quickly. A relatively moderate rise in interest rates could result in market-value losses that far exceed the credit losses that would result from severe default risk scenario, based on Fitch’s stylized ‘BBB’ U.S. corporate bond example.

Potential market losses in dollar terms have increased significantly in the past ten years due to duration extension and the surge in corporate bond issuance, notably in ‘BBB’ category bonds. However, even with the skew down the credit spectrum, credit losses would still be secondary to MTM losses.

The risks are generally lower for longer term, income-oriented financial institutions, such as insurance companies, with appropriate asset-liability management practices. Mutual funds, one of the top three investor types, could face significant redemptions and hence liquidity needs in a shock scenario. Short-term trading-oriented financial institutions and other performance sensitive market participants are likely to face greater pressure to sell into falling markets as a result of liquidity, leverage, regulatory and other considerations.

Excerpts From The Study US Corporate Bond Shock- Risks And Mitigants

A systemwide increase in duration exposure in fixed-income asset pools and increased levels of outstanding low-coupon debt have elevated investor exposure to mark-to-market (MTM) losses in the event of an accelerated U.S. corporate bond sell-off. Losses could be triggered if inflation expectations become de-anchored and interest rates rise quickly. A bond shock would pressure investors holding long-duration, fixed-rate securities in the U.S. and globally.

Interest Rate Risk Dwarfs Credit Risk

Potential market losses in dollar terms have increased significantly in the past ten years due to duration extension and the surge in corporate bond issuance, notably in 'BBB' category bonds...

The potential “bond bubble” is vastly more sensitive to interest rate risk than credit risk for investment-grade U.S. corporate bonds. Fitch Ratings’ analysis of a stylized ‘BBB’ U.S. corporate bond illustrates that even a relatively moderate interest rate increase could result in market-value losses far exceeding credit losses in even a severe default risk scenario.

Potential market losses in dollar terms have increased significantly since our last analysis in 2011, driven by the surge in corporate bond issuance, duration extension and the increase in ‘BBB’ category bonds. However, even with the greater skew down the credit spectrum, credit losses are still a secondary part of the story.

The relatively low direct ratings impact of a potential bond shock reflects the mitigants available to rated entities to resist selloff pressure (e.g. insurance companies, pension funds, short-term funds) and absorb MTM losses (e.g. banks). Contagion effects of a sell-off could tighten financing and performance conditions that have much greater implications for credit ratings.

Spillover Risks Unpredictable & Substantial

A rate shock could have material implications beyond the direct MTM effect on bond holdings. Potential exists for large and sudden redemptions by mutual fund investors — a significant investor group and a principal transmission channel — since the funds can face “fire-sale” pressures in a market stress.

A vicious cycle of increasing market volatility and decreasing liquidity may lead investors to de-risk and rotate strategies, pressuring market prices further. Liquidity demands from redemptions, cashflow mismatches, increased collateral requirements and capital calls could inflate liquidation of positions. The financial system’s rising interconnectedness could exacerbate knock-on effects. Market expectations that the U.S. Federal Reserve (Fed) act as the backstop for market liquidity has underpinned investor confidence and increased risk-taking. This makes investors’ response to market volatility more unpredictable, potentially beyond the Fed’s ability to stabilize.

Build Up of the Corporate “Bond Bubble”

Declining yields and global quantitative easing (QE) have fueled corporate debt growth over the past decade, and the pandemic has pushed prevailing trends to extremes. The low rate environment also changed the corporate bond market’s risk profile, adding to the potential for a “bond bubble,” which could result in significant market-value losses for investors in a rate shock scenario if inflation pressures intensify and fears trigger a sell-off.

 

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