(Bloomberg View) -- In the 1970s, the Nobel Prize-winning economist George Akerlof pioneered a theory about used cars to explain information asymmetry. In short, he explained that because the sellers have access to better information about a particular automobile, they must provide warranties to reassure wary consumers they aren’t buying lemons. Uncertainty about quality is what Akerlof saw as “adverse selection” that can drag down an entire market.
Akerlof’s lemon theory may have merit in the investment-grade corporate bond market. Years of buoyant issuance have provided borrowers and syndicates with the incentive to market lower quality bonds as high-rated corporate bonds became scarcer due to increased demand from index funds and limited alternatives to safe assets such as Treasuries. This presents a potential lemon problem for investors.
It’s hard to imagine that in a world awash with debt there’s actually a dearth of high quality government bonds. But that's the case, and it's largely because of new capital, collateral and liquidity requirements after the financial crisis. As a result, noncommercial entities such as central banks, pensions, insurers and agencies have had to significantly increase their share of outstanding government bonds. The reduction in net available safe assets has had consequences for quality and value in other parts of the bond market.
High Quality Debt is Scarce
Take investment-grade corporate bonds, which have seen a boom in issuance since the financial crisis as investors search for yield and view the securities as a substitute for Treasury debt. That demand caused yields to drop to record lows, leading speculative-grade issuers to jump on the bandwagon and weakening the quality of the overall corporate debt market. The stakes are high. Combined, issuance of investment- and speculative-grade credit now comprises almost 27 percent of total U.S. debt issuance, up from less than 15 percent pre-crisis. Foreign holdings of U.S. investment-grade debt have swelled to $3.5 trillion, and large asset managers increased their holdings to $4.5 trillion between 2008 and 2015, as estimated by the Bank of International Settlements.
Bull Market in New Issuance
When quality deteriorates, there should be an impact on price and value. And yet, the corporate bond market’s “new issue concession,” which is basically a sweetener provided to investors to buy a new deal, has been falling since 2012. Even though bonds rated BBB are a bigger share of issuance relative to those rated AA and higher, concessions for AA and higher bonds are only about half that of BBB, below the long-term average. In some sectors, there is even a negative concession, although some of that may suggest limited performance potential following issuance.
Passive index funds and exchange-traded funds focused on corporate bonds have attracted more than $100 billion since 2015. That money is funneled into credit markets not based on the merits of the underlying borrowers, but in order to meet index weight requirements. And because new issues make up about 20 percent of index market capitalization, a sort of "crowding out" effect has taken place as passive managers scoop up these deals and force active managers into the market for existing, or “on the run,” corporate bonds, causing valuations for those securities to become excessive. This can be seen in the difference in yields between on- and off-the-run bonds. That spread has turned negative in some cases, a sign of benchmark issues becoming overvalued.
On-the-Run Spreads Turn Negative
Akerlof said the market for used cars was just an experiment to prove his theory. Yet, the corporate bond market today has the look and feel of a bunch of lemons. Characteristics such as large cross-border holdings, shrinking concessions, liquidity concerns and information asymmetry by syndications could be straight out of Akerlof’s playbook. The risk for investors is that they mistake historically tight valuations for an alternative to safe assets.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Ben Emons is chief economist and head of credit portfolio management at Intellectus Partners LLC. The opinions expressed are his own.
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