Investor love risk-free bonds, but is it possible to have so many of them?
If demand for an asset ballooned by 300% in a decade, then you might smell a bubble. This describes the rise of AAA-rated debt. In 1999, about $1.5 trillion AAA-rated securities were issued globally. In 2009, AAA-rated issuance peaked at over $6 trillion. Are we in bubble territory?
Check out the following chart from a report by the BIS and Basel Committee's joint forum:
Tracy Alloway at the Financial Times Alphaville blogs says that this could be the most important chart in the world right now. Is this a clear indication that the rating agencies and investors are both out of their minds? The chart shows two things. First, AAA-rated security issuance has grown at an extremely rapid pace over the past decade. Second, the portion of bonds that are AAA-rated has also grown significantly, to more than 50% of all fixed-income bonds issued, from around 20% in 1991.*
The 2009 Resurgence
The story through 2007 looks clear enough: asset-backed securities became very popular. Then they played a big role in the financial crisis and investors lost their taste for them. After AAA-rated bond issuance fell in 2007 and 2008, it jumped to a new high in 2009. This time, corporate and sovereign debt led the growth. Why did that happen? I can think of at least three possible explanations.
Flight to Quality
First, why did investors want so many risk-free bonds? In 2009, the global recession peaked. The uncertainty that it caused drove investors to seek super-safe securities. That helps to explain the strong demand for AAA-rated bonds. Investors wanted the closest thing they could find to a sure thing.
Crazy Low Interest Rates
In 2009, central banks had interest rates very low, which made it a great time to borrow. This could explain the growth in AAA-rated corporate bond issuance. Strong firms took advantage of the cheap borrowing, as you can see from the chart. Of course, some also may have needed some extra cash, due to the global recession.
Government Stimulus Efforts
As unemployment rose across the globe, a number of nations took actions to stimulate their economies. That meant budget deficits, which required more borrowing. As a result, sovereign debt rose. Let's look at the U.S. as a case study. In 2007, it issued just $235 billion in debt. In 2009, issuance rose to over $1.4 trillion. The U.S. alone makes up more than 40% of the AAA-rated sovereign debt issuance in 2009.
So Is It Crazy?
Those reasons make sense, but that doesn't mean that having this magnitude of supposedly risk-free bonds are out there is sensible. Is there any way to justify the rating agencies' decisions?
Creditworthiness is ultimately based on a borrower's willingness to and ability to pay. For sovereign debt, nations generally exhibit a strong desire to avoid default, as most understand the huge benefit a AAA-rating provides (which is, incidentally, what makes the U.S. debt ceiling crisis so insane). The question, then, is whether the rating agencies are correct to say that the AAA-rated nations have the ability to pay back all this debt. That would have to be examined on a case-by-case basis.
So it's hard to tell if this is a real bubble or not. It might simply indicate a shift where the demand for AAA-rated debt has grown and the supply has ballooned as well to meet that demand. If this is a bubble, one thing that could cause it to pop is a sudden drop in investor demand for these bonds. Then, these nations would have to pay considerably more on their debt. If the yields on the debt they roll over increase enough, some might have a harder time making interest payments. But this is precisely the sort of stress scenario that the rating agencies are supposed to consider. Let's hope they got it right.
*Note: Initially, I had written that AAA-rated bonds were just 15% in 1999, which was incorrect. So this has been revised to note the 20% portion in 1991. Still, the percentage of AAA-rated bonds has clearly grown a lot over the past few decades.
Image Credit: andrewmalone/flickr