Yellen comments don't get much market traction

Thu May 8, 2014 7:58pm EDT

NEW YORK, May 8 (IFR) - Janet Yellen's first public comments about market risks this week were largely shrugged off by the market itself, where the hunt for yield doesn't look to be going away anytime soon.

The new Fed chairwoman pointed to growing issuance of leveraged loans and high-yield bonds, as well as a loosening of underwriting standards, in her testimony to Congress.

But while her focus on specific asset classes raised some eyebrows, market players are still betting on a prolonged run of low interest rates and accommodative policies from the Fed.

And that means risk-on mentality - which has fostered the froth Yellen was supposedly warning about - will continue for now.

"Mentioning high-yield and leveraged loans in testimony now sends a subtle signal to the financial community: 'We are watching, don't get too excited,'" said Oleg Melentyev, head of US credit strategy at Deutsche Bank.

"They have to send signals one year in advance for the markets to stay calm," he told IFR.

"The fact that these markets have been mentioned very specifically by name tells us that when the FOMC makes decisions about how fast to taper - and to engage in increasing the Federal Funds Rate - this will be part of their consideration."

Another senior banker said: "The Fed seems to be walking a tightrope of tamping down froth perceived to be developing in financial markets whilst continuing to want to stick to its low interest rate policy."

He added: "That is very unlikely to be a fulfilling strategy."

OLD TALK

Hot market conditions that Yellen noted have been building for some time.

While primary high-yield issuance so far this year is at US$108.8bn, slightly down from US$125.6bn in the same period in 2013, issuance by fringe investment-grade credits - with ratings on the riskiest band of high-grade bonds - is at US$135.9bn versus US$120bn a year earlier.

And ominous aspects of the pre-crisis days have again raised their heads, with a surge of PIK toggle trades, dividend recaps and Triple C issuance, as well as a rapid tightening of the mezzanine tranches in structured finance trades.

More broadly, there has been an almost unending stretch of record low spreads and all-time high primary debt issuance.

But while her predecessor Alan Greenspan's infamous "irrational exuberance" comment sparked an equity market sell-off, Yellen's remarks seemed to fall on deaf ears.

Just one day after her comments, the US high-yield market printed more volume than in all of the previous week.

"There is indeed a search for yield, but that's been happening for a while," said one senior investment banker.

"And other Fed speakers have mentioned the risks of this behavior, so I am not sure what these latest remarks are supposed to indicate. They have never said we should stop doing deals."

NOT THE ONLY WARNING

To be sure, Yellen is not the only observer of late to note looser structures in the credit markets.

Last month, Covenant Review warned that protections in covenants are being compromised.

The publication said restricted payments covenants in Rice Energy's US$750m senior notes due 2022 included a carveout that could significantly undermine protection if the issuer is acquired.

And a similar carveout was included in the recent offering from Exco Resources.

But several bankers told IFR that, amid the current red-hot demand in the market, the time from a deal's origination to its distribution has narrowed so much that banks are not in a position to make a moral judgment about structural risks.

"If we don't do those deals, someone else will and we would be missing out on important fee-earning mandates," said one.

"Structures are getting riskier with each day, but there is sufficient appetite for these trades to get done."

Deutsche Bank's Melentyev meanwhile said that the Fed could only have limited scope to tighten the reins on leveraged buyouts.

"If they reacted suddenly to a surge in LBOs, then we would have a repeat of the rate volatility we saw last May and June," he said.

"By the time the LBO market comes back, it will be too late at that point for the Fed to do something about it." (Reporting by Shankar Ramakrishnan; Additional reporting by Danielle Robinson; Editing by Marc Carnegie)

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