A key dynamic that has been holding down bond yields since the global financial crisis is poised to ease next year — presenting a test to riskier parts of the market, an Oxford Economics analysis said.
In the aftermath of the crisis, banks and shadow financial institutions in developed economies sharply cut back their issuance of bonds to the tune of about US$4 trillion, according to the research group’s tally.
That happened thanks to banks shrinking their balance sheets amid a regulatory crackdown, and due to a contraction in supply of mortgages that were regularly securitized into asset-backed bonds, it said.
“Against stable demand for fixed-income securities, the large negative supply shock created an increasingly acute shortage of these assets,” said Guillermo Tolosa, an economic adviser to Oxford Economics in London, who has worked at the IMF.
The effect of that shock was an “almost decade-long yield squeeze,” he wrote in a report distributed on Tuesday.
That compression “may start to ease in 2018,” he added.
The market for financial company debt securities in G7 nations shrank after the 2009 global recession and now appears to have flat-lined.
Continued demand among mutual funds, pensions and insurance companies for fixed income then created the opportunity for nonfinancial companies to ramp up issuance, Tolosa wrote.
It is one of a number of supply factors that have been identified explaining why bond yields globally remain historically low.
Perhaps the most well-documented one is the quantitative easing programs by the US Federal Reserve, the European Central Bank (ECB) and Bank of Japan that gobbled up about US$14 trillion of assets.
Another, identified by analysts including those at Oxford Economics, is an effective shortage of safe-haven investments — the result of emerging markets generating increasingly more wealth, but not producing assets viewed by global investors as on par with developed-nation government bonds.
Low inflation rates are also seen contributing to low yields.
Tolosa’s analysis suggests that the Fed’s quantitative easing has had less of an effect than generally accepted, as the initiative was “more than offset” by increased public-sector borrowing.
The large portfolio rebalancing in fixed income was instead “essentially a switch within private-sector securities,” Tolosa wrote.
There was a “massive shift” from financial securities into Treasuries, along with nonfinancial corporate and overseas debt, Tolosa added.
“This explains a considerable part of the post-crisis surge in demand for other spread products and the issuance boom for global nonfinancial corporates and emerging-market borrowers,” Tolosa wrote.
During the decade through 2007, 10-year US Treasury yields averaged 4.85 percent, but since the start of 2009 they have averaged just 2.46 percent — giving investors incentives to find higher rates elsewhere.
However, that is changing. Financial institutions are “now back issuing more, finally keeping their supply of securities to the market stable,” Tolosa wrote.
Along with the Fed’s balance-sheet reductions and the expected tapering of ECB asset purchases, that “makes markets with stretched valuations such as high-yield corporates more vulnerable,” he wrote.
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