Do Low Bond Risk Premiums Predict Financial Instability?

Source: Thinkstock

One reason that many monetary policy hawks cite for raising the target federal funds rate sooner rather than later is that risk premiums on bonds could spike sharply when the central bank finally begins to tighten its monetary strategy after a long period of accommodation. This is kind of like a patient going through withdrawal after a doctor finally decides that it is time to terminate a prescription for pain medication after major surgery. The theory is that after taking the meds for so long, the patient — the financial markets, in this case — becomes addicted, and tapering the prescription too quickly could lead to painful withdrawal effects.

Many monetary policy experts, particularly doves, have questioned the validity of this theory, but recent data have brought the hawkish perspective to the forefront. Speaking at the International Monetary Fund in Washington, D.C., on Wednesday, Federal Reserve Chair Janet Yellen — generally believed to fall on the dovish side of the spectrum — called attention to some dark clouds on the monetary horizon.

“Corporate bond spreads, as well as indicators of expected volatility in some asset markets, have fallen to low levels, suggesting that some investors may under-appreciate the potential for losses and volatility going forward,” Yellen said.

According to Bloomberg, the Markit CDX North American Investment Guide Index, a gauge of credit worthiness, declined about 1.9 basis points to 55 basis points at the end of June to its lowest reading since October 2007. “Valuations are getting stretched,” Jack Flaherty, investment manager at GAM, a part of GAM Holding AG, told Bloomberg. “You’d rather be early in getting out because when it does turn, it could be more violent than expected.”

However, a recent research paper by the Federal Reserve Bank of Chicago says that the correlation between the risk of financial instability caused by disruption in the bond risk premium and time of exit from an accommodative policy is not necessarily strong. Risk premium is the premium paid by a bondholder for the credit and interest rate risk being carried by that person.

When risk of a default or risk from interest rate volatility is high, the premium tends to be higher. The danger in this game is that risk premium can suddenly shoot up. In other words, the yields on these bonds could rise dramatically when the markets sense that the Fed is likely to tweak interest rates unfavorably — that is, higher. Bond prices move in the opposite direction to bond yields, so when yields rise, prices fall, and vice versa.

“Sixty years of data suggest that large increases in bond risk premiums are independent of the recent level or change in risk premiums or federal funds rate,” the Chicago Fed report said.

The way it works is this: Yield-hunting investors get into riskier investments, thereby depressing the premiums further. Once there are too many such yield-seeking investors in the market, it creates a real risk of a sharp spike in the risk premium if risk appetite shrinks due to anticipated monetary policy action by the Federal Reserve. By then, it may be too late for some investors to exit these investments, thereby losing money.

Based on a study of the pattern of crests and troughs in the risk premiums of three benchmarks — Moody’s Baa-Aaa spread, the Kim-Wright 10-year term premium, and the Gilchrist and Zakrajšek corporate expected bond premium (EBP) — in the last six decades, the Chicago Fed concluded that “the current levels and past changes in risk premiums are poor predictors of the risk of future large increases in risk premiums.” It further observed that, “The level and change in the real fed funds rate and risk premiums are insignificant in most specifications. The hazard model suggests large increases in risk premiums are less likely when risk premiums have been depressed or have declined over the past year. ”

Instead of trying to reduce instability in the financial markets by targeting monetary policy, the Fed could ensure a sharp correction in risk premium is absorbed by financial institutions. This could be done by asking banks and other financial institutions to maintain sufficient capital buffers to absorb such losses. The most important objective of monetary policy is maintaining price stability, economic growth, and full employment, and ideally it should remain so, instead of having to firefight risks of financial instability.

More From Wall St. Cheat Sheet: