There have been rumblings from credit strategists at Citi, Société Générale, and BofA Merrill Lynch in the past few days warning clients that if Treasury bond yields rise too quickly this year, there could be a total bloodbath in credit markets.In a note to clients this morning, Goldman Sachs strategist Charles Himmelberg says these fears are totally overblown, writing that “the risk posed to credit by a selloff in rates is very low.”
The “big picture” here is that investors have continually moved out on the risk spectrum as the zero interest rate policy environment has dominated markets since the financial crisis in 2008. Since corporate bonds typically pay higher yields than government Treasury bonds, investors have piled money into corporate bonds via mutual funds and ETFs – and those funds now account for a significant size of the market.
The concern is that, when investors realise that they are going to get negative returns on their corporate credit investments in these mutual funds, they will head for the exits, creating a messy, forced-selling situation – and because Wall Street dealers have been decreasing their inventories of corporate bonds to comply with financial regulation known as the “Volcker Rule,” there would be no one left to take the other side of the trade from the mutual-fund sellers, causing a credit market disaster.
There’s a catch, though. This line of thinking not only assumes that interest rates are going to rise, but it also assumes that they rise rapidly. This caveat has been made clear by those strategists warning of this type of forced-selling scenario.
Goldman’s Himmelberg tries to push back against some of these concerns in his note. He writes:
A second risk relates to the concern of many clients that fund flows to corporate bonds – which have been so robust at times over the past several years – could suddenly turn negative. This concern is commonly motivated by the fear that retail ‘newcomers’ to credit investing (via mutual funds and ETFs) are insufficiently aware of how much rate risk they own, and may therefore react strongly when faced with negative returns caused by a selloff in rates.
We think such concerns are overdone. For one, many of these same investors will have also been burned by equities over the past decade, and may not be so quick to abandon fixed income for equities. Second, even if this ‘great rotation’ does materialise, we think credit should suffer less than pure rates exposure or, for that matter, money market funds and bank deposits. Third, we think institutional investors would welcome such an exit and exploit the opportunity to add risk at better levels.
And fourth, fund flows are not destiny. Indeed, in contrast to what we have argued was true during the 2009-2010 period, our recent estimates reveal very little correlation between fund flows and spread moves in credit space. In short, we are not concerned about fund flow reversals even if they should materialise (which they have yet to do, notwithstanding the remarkably heavy inflows into equities over the past few months).
The other crucial input to Goldman’s view that makes it contrast with that of strategists at other banks is its belief that 10-year Treasury yields will only reach 2.25 per cent by the end of 2013. That implies only around a 0.3 percentage-point rise from today’s levels – hardly constituting a major selloff in the Treasury market.
Still, that’s what everyone seems to be worried about at the moment, based on colour from strategist meetings with clients – a rapid increase in Treasury yields, sparked by better than expected developments in the U.S. economy.
Himmelberg thinks this is highly unlikely:
The most plausible ‘growth’ scenario under which a selloff in rates could be bearish for credit spreads would be a scenario in which inflationary pressures turns out to be unexpectedly high.
In addition to being highly unlikely given the current state of the economy, there is very little historical precedent for ‘better growth’ causing ‘higher inflation’ to such a degree that it has a net negative impact on risk sentiment.
In macro scenarios where the first-order driver of the scenario is growth, we think the offsetting effect of inflation (fueling a tighter monetary stance, etc.) would likely be secondary.
However unlikely, if inflation does unexpectedly heat up, or a surprise increase in hiring and wage inflation indicates that unemployment is more structural than previously assumed, Himmelberg acknowledges that Goldman’s “sanguine view could conceivably unravel.”
READ MORE: The Street Warns Of A Messy Credit Selloff >