Cai Jin

Exuberance in bond market sparks concern

High yield could become high grief if interest rates rise suddenly and bond prices plunge

A big worry among big-time investors is the tide of irrational exuberance sweeping across global bond markets.

Take the bond-buying frenzy here. Just two weeks ago, British-based insurer Prudential attracted a staggering US$12 billion (S$16.3 billion) worth of orders for its US$1 billion sale of a bond-like instrument known as perpetuals.

Even more amazing was that it was able to draw so much interest despite other big issuers such as United Overseas Bank and Societe Generale already draining the market of huge sums with their own perpetual offerings.

Yet the interest for bonds is not just confined to new issues. If you track the weekly fund flow reports, you will find that investors are also snapping up bonds in a big way in the secondary market as they switch out of stocks.

Consider the week to last Wednesday when investors poured US$7.9 billion into bond funds while taking out US$2.6 billion from equity funds, according to Citi Investment Research.

So why should roaring interest in bonds be of concern to anyone? Bond prices move in the opposite direction to yield. And with bond yields falling to zero or negative because of massive bond purchases by central banks, one worry is that this may be fuelling a big bubble in the debt market as bond prices soar.

The Prudential Building, as seen from Fenway Park, home of the Boston Red Sox. Prudential recently attracted US$12 billion worth of orders for its US$1 billion sale of perpetuals, a bond-like instrument. PHOTO: AGENCE FRANCE-PRESSE

And, like all asset bubbles, it may end in grief if interest rates were to go up unexpectedly and cause bond prices to tumble.

The worry is best articulated by Mr Larry Fink, the chairman of money manager Blackrock, when he highlighted the plight of the average saver who had been whiplashed by the paltry returns on his savings because of the extremely low interest-rate environment. He noted that not only have central banks been ineffective in stimulating the economy with their actions, but they also ended up punishing savers by encouraging them to take extreme risks to earn a decent return.

Mr Fink observed that this would have included purchases of less liquid asset classes and increased levels of risk, with potentially dangerous financial and economic consequences.

In Singapore, one obvious area of concern would have been the corporate bonds issued by highly indebted companies that risk-averse investors would normally have given a miss.

But these bonds are now being eagerly snapped up because their mouth-watering yields are much higher than the Singapore Saving Bonds or what bank saving accounts can offer.

Yet, most of them are not rated by credits ratings agencies and nobody knows if these corporate bonds are investment grade or junk.

There is another concern: A possible distortion of the credit costs for high-yield bonds because of the tsunami of money flooding the corporate bond market.

Bloomberg quoted analysts from credit ratings agency S&P Global Ratings who noted that there is "limited differentiation" on borrowing costs between blue-blood bond issuers and riskier borrowers and that "it is not much more onerous to finance a levered balance sheet" than a good-credit issuer.

What makes the situation even more irrational is that the corporate bond offerings of some of Singapore's biggest companies are drawing such a strong demand that they are artificially lowering the borrowing costs for weaker companies. This is despite the heightened threat of non-payments by riskier borrowers, with the Singapore bond market alone suffering defaults by Indonesia's PT Trikomsel Oke and fishery group Pacific Andes Resources in the past 12 months.

Further afield, the world of bonds has turned even crazier.

With central banks in Europe and Japan pushing benchmark interest rates below zero and economic uncertainties whetting investors' ravenous appetite for bonds, this has pushed the yield on more than US$10 trillion of bonds into negative territory. This means that besides getting no return on his investment, an investor will be receiving less than what he paid for the bond when it is redeemed - a strange phenomenon likely to cost investors billions of dollars.

In some European countries, investors are so desperate for whatever yield they can get that they are even willing to plough their money into 50-year or even 100-year bonds issued by their governments, despite the low returns they offer.

This is because such long-term bonds will carry a slightly higher coupon than one of shorter maturity. This makes them look like bargains to investors who would rather stick to government bonds where the risk of default is virtually zero than take their chances in other types of investments.

It leads star bond fund manager Bill Gross to describe the absurd situation as a "supernova that will explode one day".

Worse, the European Central Bank is making this dilemma even more acute by buying up corporate debts of top-notch European firms as well, pushing the yields on certain bonds issued by them into negative territory as well.

But it is the stress that may erupt in the United States bond market if interest rates go up that sparks concern. By some estimates, a one-percentage-point rise in US Treasury yields would trigger a US$1 trillion loss for bond investors as prices tumble.

There is another concern worth airing - the estimated US$10 trillion of US corporate debts coming due in the next five years.

It is such a big sum that if some of the weaker companies fail to get debt refinancing they may go under - and this may spell fresh troubles for the financial markets.

One thing is for sure. Bonds are not 100 per cent foolproof investments as there is a likelihood that companies can fail and not repay the money they have borrowed. The sooner an investor realises this, the better.

A version of this article appeared in the print edition of The Straits Times on June 13, 2016, with the headline 'Exuberance in bond market sparks concern'. Print Edition | Subscribe