Private sector leverage and the risk of a credit bubble
FiveThirtyEight reports that a recent speech by Jeremy Stein, with the wonky title “Incorporating Financial Stability Considerations into a Monetary Policy Framework,” garnered attention for its bold argument that the Fed should withdraw stimulus or raise interest rates to prevent the growth of a bubble — this time in the bond market, rather than in real estate or stocks. What are the signs of a bubble in the bond market? Stein points to three things: first, the rising level of private-sector debt as a percentage of the U.S. economy; second, narrowing spreads between risk-free Treasuries and corporate bonds; and third, the growing proportion of corporate debt going to riskier companies, i.e. companies that have a greater likelihood of defaulting on their loans.
Atif Mian and Amir Sufi writes that the financial stability concerns of Governor Stein and others are based on something more than just instinct. Stein, for example, cites the work of two Harvard Business School professors, Robin Greenwood and Samuel Hanson whose research argues that a good indicator of credit market overheating is the share of all new corporate debt issues coming from low-grade issuers. The high yield issue share peaks about two years before major meltdowns we’ve seen in credit markets. The high yield share in 2012 and 2013 indicates elevated risk, but not an impending disaster. For example, the 2013 high yield share is still below the peaks seen prior to other credit crashes. This may be driven in part by the fact that investment grade firms are also issuing a ton of debt. So in some sense the denominator is rising so fast that the high yield bond issues cannot keep up with it.