Early last month, Fed Governor Jeremy Stein gave a speech titled Overheating in Credit Markets: Origins, Measurement, and Policy Responses that raised the question of whether or not we might be seeing a bubble, and if so what might be done about it.
You've probably heard a lot of talk about the aggressive lengths that money managers are going to to "reach for yield" in the context of this ultra low-rates environment.
Stein didn't sound too fearful yet, but the overall concern is that we could be setting up another credit bubble, just like before the recent crash.
In the latest version of their US Interest Rates Strategist letter, Morgan Stanley's Vincent Reinhart and Matthew Hornbach look at the scene in corporate credit and determine that the market might be "modestly rich" rather than straight-up "overheated."
Three charts from their work stand out, that nicely call into question the idea of a bubble.
First, although junk bond (or high-yield) yields are at record lows, actual spreads (where those yields are relative to risk-free Treasuries) remain well off their lowest levels.
The chart is a little bit noisy for the unfamiliar, but the line to watch here is the green line, which shows the average high-yield spread, or the average difference between what high-yield credit pays and what risk-free Treasuries pay. The current difference is about 500 basis points, well above the less then 300 basis points that we saw pre-crisis.
 Morgan Stanley |
The next chart shows what companies are doing with the proceeds of their high-yield borrowing. Whereas in 2007, high-yield debt issuance was going to things like leveraged buyouts and other acquisitions, these days the proceeds are going overwhelmingly to refinance old debt, which is just really prudent financial management.
 Morgan Stanley |
And then finally, the underlying condition of high-yield debt issuers is in better shape these days. They have more cash relative to debt, suggesting that their credits are fundamentally safer.
 Morgan Stanley |
None of this is to suggest that there aren't causes for concern. And you should read Jeremy Stein's speech (here) but the evidence of a raging bubble in this space has to be tempered by signs that prices aren't totally out of whack, and issuers of high-yield debt aren't going crazy.
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