Investor Alert: Global trade growth falling off, unease in the US dollar funding market , the debt market is broadcasting a dangerous message


The Big, Dangerous Bubble in Corporate Debt

The $30 trillion domestic stock market seems to get all the attention. When the stock market sets new highs, we instinctively feel things are good and getting better. When it tanks, as happened in the initial months of the 2008 financial crisis, we think things are going to hell.

But the larger domestic debt market — at around $41 trillion for the bond market alone — reveals more about our nation’s financial health. And right now, the debt market is broadcasting a dangerous message: Investors, desperate for debt instruments that pay high interest, have been overpaying for riskier and riskier obligations. University endowments, pension funds, mutual funds and hedge funds have been pouring money into the bond market with little concern that bonds can be every bit as dangerous to own as stocks.

Unlike buying a stock, which is a calculated gamble, buying a bond or a loan is a contractual obligation: A borrower must repay a lender the borrowed amount, plus interest as compensation. The upside in a bond is limited to the contractual interest payments, but the downside is theoretically protected. Bondholders expect to get their money back, as long as the borrower doesn’t default or go bankrupt.

But for much of the last decade, risk has been mispriced to a staggering degree. In other words, the prices of bonds (and corporate loans) have not accurately reflected the riskiness of the underlying borrower’s credit. A company that is a poor credit risk, because it has too much debt or is struggling, should have to pay higher rates of interest. And investors would expect a higher yield — roughly the interest rate divided by the price paid for the bond or loan — for taking on that risk. Since the financial crisis, that simple calculus has been upended. Until recently, investors have been paying higher prices for the debt of riskier companies and not getting properly compensated for that risk.

The International Monetary Fund has noticed. In a recent blog post, an I.M.F. economist wrote that the current debt craze was “fueled by excessive optimism among investors,” and he added: “When the economy is doing well and everybody seems to be making money, some investors assume that the good times will never end. They take on more risk than they can reasonably expect to handle.”


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