Moonwalking bears and underwater icebergs hidden risks in markets speech by alex brazier

1. Moonwalking bears and underwater bergs: hidden risks in markets
Alex Brazier
Executive Director for Financial Stability Strategy & Risk, Bank of England
26 April 2018
London Business School Asset Management Conference 2018

2. Two types of hidden risk in markets
Bears: in plain sight Bergs: in the system
Did you see the
moonwalking bear?

3. Little compensation for risk in global corporate debt markets
Sources: ICE Bank of America Merrill Lynch, Federal Reserve Bank of New York and Bank calculations.
Note: The chart shows how the yield on an index of US-dollar investment-grade corporate bonds (in orange) splits into two components. The first component (in blue) is the risk-free
interest rate, which reflects expected Federal Funds rates over a period equal to the (7-year) duration of the index. The second component (in purple) is the difference between the yield
and the first component, and reflects the term premium and credit spread.
Components of yield on US-dollar investment-grade corporate bond index
0
1
2
3
4
5
6
7
8
9
10
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18
Per centRisk-free interest rate
Term premium + credit spread
Yield

4. …Very unusual in a US monetary policy tightening phase
Sources: ICE Bank of America Merrill Lynch and Bank calculations.
Cumulative changes in US-dollar investment-grade corporate bond yields
-2
-1
0
1
2
3
0 1 2
Per cent
Years since first increase in federal funds rate
1994
1999
1988
2004
Current

5. Price of default insurance fallen… …but risk of default hasn’t
0 20 40 60 80 100 120
March 2016
January 2018
Default probability (basis points)
Density
0 50 100 150 200 250 300 350 400
March 2016
January 2018
CDS premium (basis points)
Density
Sources: Bloomberg, Credit Benchmark and Bank calculations.
Note: The charts show fitted densities of CDS premia and default probability estimates for corporate debts referenced in the current CDX.NA.IG credit default swap index. The CDS
premia are annual amounts on five-year senior CDS contracts and the default probabilities are aggregates of one-year ahead estimates constructed by financial institutions following
an internal-ratings-based approach to regulation.
Distribution of CDS premia Distribution of default probabilities

6. Little compensation for risk in £ corporate bonds
Components of yield on adjusted sterling investment-grade corporate bond index
Sources: ICE BofAML, Bloomberg, HMT and Bank calculations.
Note: The chart shows GBP investment-grade corporate bond yield and the expected risk free rate (based on a maturity (7 years) that is similar to the duration of the corporate bond index
over the period shown). The difference between the corporate bond yield and the expected rate is the term premium plus the credit spread. The adjusted sterling investment-grade spread
accounts for changes in credit quality and duration of the index over time.
0
1
2
3
4
5
6
7
8
9
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18
Per centRisk-free interest rate
Term premium + credit spread
Yield

7. Something more than QE at work...
Components of yield on adjusted sterling investment-grade corporate bond index
Sources: ICE BofAML, Bloomberg, HMT and Bank calculations.
Note: The chart shows GBP investment-grade corporate bond yield and the expected risk free rate (based on a maturity (7 years) that is similar to the duration of the corporate bond index
over the period shown). The difference between the corporate bond yield and the expected rate is the term premium plus the credit spread. The adjusted sterling investment-grade spread
accounts for changes in credit quality and duration of the index over time.
QE announcement
dates
No QE in effect
0
1
2
3
4
5
6
7
8
9
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18
Per cent
QE1 QE2
Risk-free interest rate
Term premium + credit spread
Yield
QE3 QE4/CBP

8. A search for yield? Past performance used as guide to future?
Sources: ICE Bank of America Merrill Lynch, Bank of England and Bank calculations.
Note: Change is calculated between 02/03/2009 and 31/03/2018.
Total return since March 2009
Investment-grade
corporate bonds
106%
Gilts
59%
High-yield
corporate bonds
382%
Cash
4%

9. Record issuance of riskier types of corporate debt recently
Sources: S&P Global Market Intelligence and Bank Calculations.
Note: Issuance is shown on a gross basis.
Issuance of high-yield bonds and leveraged loans
by UK private non-financial corporations
0
5
10
15
20
25
30
35
40
06 07 08 09 10 11 12 13 14 15 16 17 18
First Quarter Remainder of year
Refinancing value
£ Billions

10. In 2008, built up of excessive leverage via derivatives = firesales
AIG builds up leverage through $400bn of CDS on
MBS
MBS credit
quality declines
AIG credit
rating
downgraded
Margin call
Firesales?
US Government
support

11. Need for diagnostic tools I: collateral calls
Liquid assets to
meet the call
Collateral call

12. In 2008, a run on money market funds. Now reformed.
First-mover
advantage
Lehman defaults
Primary Reserve Fund
‘breaks the buck’
Run on US prime
MMFs and fire-sales
Commercial paper
market shuts
MMF structural
reforms
2014: US institutional money
funds become variable NAV.
2017: ‘Low-volatility’ NAV funds
introduced in Europe.
:

13. Increasing share of corporate bonds held in open-ended funds
Funds’ holdings of corporate bonds
Sources: Bank of England, Thomson One, ECB, Federal Reserve, Morningstar and Bank calculations.
Note: United Kingdom: sterling corporate bond funds (open-ended and ETFs) total net assets as a share of all outstanding sterling corporate bonds. United States:
mutual funds' holdings of corporate and foreign bonds as a share of all outstanding corporate and foreign bonds. Euro Area: euro-area open-ended holdings of
bonds issued by euro-area non-financial corporations as a share of total. United Kingdom data until July 2017. United States data until Q1 2017. Euro Area data
until Q2 2017.
0
5
10
15
20
25
30
2008 2017
United Kingdom (sterling-focused corporate bond funds)
United States (corporate and foreign bonds held in the United States)
Euro Area (PNFCs)
Percentage of total

14. Open-ended funds are much safer. But could there be a more
subtle first-redeemer advantage?
Sources: Morningstar and Bank calculations.
Note: These estimates are for European-domiciled open-ended funds, excluding ETFs, MMFs and funds of funds.
Fund redemptions following 1% fall in asset value
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
Equity Commodities Mixed (equity/fixed
income)
Government bond Corporate bond
Per cent of assets
Redemptions as percentage of total assets
following 1% loss

15. At same time, dealers have become less active in
market making
Sources: BofA Merrill Lynch Global Research, Dealogic, EPFR Global, Federal Reserve Bank of New York, SIFMA and Bank calculations.
Note: Response (at 1 week) of US dollar-denominated high-yield corporate bond spreads and US primary dealers’ inventory in these securities to a one standard
deviation decline in asset manager demand (of the pre-crisis period). Based on the SVAR model. Pre-crisis refers to 2004-2006, post-crisis refers to 2012 -
February 2015.
Response of US high-yield corporate
bond dealer inventories and spreads to
a negative demand shock (i.e. sales)
from asset managers
Dealers’ response to high-yield bond sales
0
2
4
6
8
10
12
14
16
18
20
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
Pre-crisis Post-crisis
Basis points of
market size
Basis points
Inventory Spread

16. Need for diagnostic tools II: System simulations
Redemptions
from funds
Amplification of
market shock
Reduction in
market-making
capacity
Forced asset
sales
Market shock
Baranova, Y., et al. (2017), ‘Simulating stress across the financial system: the resilience of corporate bond markets and the role of
investment funds’, Bank of England Financial Stability Paper, no. 42, (July)