The corporate debt market contains “moonwalking bear” risks to financial stability which are hiding “in plain sight”, according to a top Bank of England official.
Alex Brazier, executive director for financial stability at the Bank, warned investors are accepting lower returns for the same amount of risk as previously.
The bear risks, named after a viral video showing how easily observers can be distracted, contrast to the “iceberg” risks which lurk under the surface of financial markets.
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“In global debt markets, investors seem to be willing to take the same risk for less compensation,” he said. “Appetite for risk taking has increased.”
Underlying “iceberg” risks to the financial system include derivatives using a significant amount of leverage, which can multiply losses or profits in the event of a big market move.
The Bank will examine how market moves could prompt firms to have to put up significant amounts of collateral to back up their exposures to derivatives, Brazier said. One fear is that firms could have to engage in a fire sale of assets to meet those demands, in spite of lower risks of default.
The scrutiny of financial markets comes with regulators generally in agreement that the post-financial crisis reforms have been largely carried out. Economists are now nervously scanning the horizon for the source of the next crisis, as the business cycle matures.
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Bond markets have expanded in the UK since the financial crisis after bank lending ground to a halt; policymakers have mostly welcomed the increase in choice this offers to companies looking to grow.
However, Brazier pointed to the small premium corporate bond investors earn compared to longer-term risk-free rates, suggesting “an unusual degree of investor confidence” in the path of interest rates and company earnings.
If inflationary pressures build faster than markets are pricing, interest rates could rise quickly and prompt a sell-off in debt markets.
Brazier compared the likelihood of default for firms, which has “barely changed”, he said, to the price of insuring against default using a credit default swap (CDS). Yet average annual premiums paid for investment-grade CDSs are only 0.5 percentage points of the insured amount, compared to 0.85 points two years ago, suggesting lower risks, he said.
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He also dismissed criticisms aimed at the Banks monetary policy that quantitative easing, the massive purchases of corporate and government bonds after the financial crisis, was the sole cause of the potential mispricing of risks. Investors are instead searching for higher returns on their investment, pushing them into riskier assets, he said.
Meanwhile, liquidity mismatches in investment funds which offer next-day redemptions but invest in illiquid assets could cause problems if investors try to pull their money out en masse.
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