A $4 Trillion Hole in Bond Market May Start Filling in 2018

(Bloomberg) -- A key dynamic that’s been holding down bond yields since the global financial crisis is poised to ease next year -- presenting a test to riskier parts of the market, according to analysis by Oxford Economics.

In the aftermath of the crisis, banks and shadow financial institutions in developed economies sharply cut back their issuance of bonds, to the tune of about $4 trillion, according to the research group’s tally. That happened thanks to banks shrinking their balance sheets amid a regulatory crackdown, and due to a contraction in supply of mortgages that were regularly securitized into asset-backed bonds.

"Against stable demand for fixed-income securities, the large negative supply shock created an increasingly acute shortage of these assets," said Guillermo Tolosa, an economic adviser to Oxford Economics in London who has worked at the International Monetary Fund. The impact of that shock was an "almost decade-long yield squeeze," he wrote.

That compression "may start to ease in 2018," Tolosa wrote in a report distributed Tuesday.

Using slightly different metrics, the chart above shows how the market for financial company debt securities in the Group of Seven nations shrank after the 2009 global recession, and now appears to have flat-lined. Continued demand among mutual funds, pensions and insurance companies for fixed income then created the opportunity for nonfinancial companies to ramp up issuance, Tolosa wrote -- a dynamic also seen in the chart.

It’s one of a number of supply factors that have been identified explaining why bond yields globally remain historically low. Perhaps the most well documented one is the quantitative easing programs by the Federal Reserve, European Central Bank and Bank of Japan that gobbled up about $14 trillion of assets.

Haven Shortage

Another, identified by analysts including those at Oxford Economics, is an effective shortage of safe-haven investments -- the result of emerging markets generating more and more wealth, but not producing assets viewed by global investors as on par with developed-nation government bonds. Low inflation rates are also seen contributing to low yields.

Tolosa’s analysis suggests that Fed QE has had less of an impact than generally accepted, as the initiative was "more than offset" by increased public-sector borrowing. The large portfolio rebalancing in fixed income was instead "essentially a switch within private sector securities," he said. There was a "massive shift" from financial securities into Treasuries, along with nonfinancial corporate and overseas debt, Tolosa concluded.

"This explains a considerable part of the post-crisis surge in demand for other spread products and the issuance boom for global nonfinancial corporates and emerging-market borrowers," Tolosa wrote.

Over the decade through 2007, 10-year U.S. Treasury yields averaged 4.85 percent. But since the start of 2009 they’ve averaged just 2.46 percent -- giving investors incentives to find higher rates elsewhere.

But that’s changing. Financial institutions are "now back issuing more, finally keeping their supply of securities to the market stable," Tolosa wrote. Along with the Fed’s balance-sheet reductions and the expected tapering of ECB asset purchases, that "makes markets with stretched valuations such as high-yield corporates more vulnerable," he concluded.

To contact the reporter on this story: Christopher Anstey in Tokyo at canstey@bloomberg.net.

To contact the editors responsible for this story: Christopher Anstey at canstey@bloomberg.net, Adam Haigh