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Fed Study: “Little Evidence” of Bubbles in Bond Market

A Federal Reserve Board economist found that corporate bond markets historically have not been “frothy” despite fears of bubbles.

Fears of a bubble in the bond market may be misplaced, according to new research from the Federal Reserve Board.

In a paper this month, senior economist Yoshio Nozawa made a case against “frothy” corporate bond markets, arguing that any mispricing in the asset class is “economically insignificant.”

“If there is froth it the corporate bond market, then long-run bond risk premiums would be too low relative to the [stock market] benchmark during the period with credit expansion,” he wrote. “There is little evidence that the bond risk premiums are too low prior to recessions.”

The findings come after multiple warnings from analysts and asset managers over the last year that a sustained period of low interest rates has created a bubble in the bond market. Less than a month ago, former Fed chair Alan Greenspan said in an interview with Bloomberg that investors “are experiencing a bubble, not in stock prices but in bond prices.”

Nozawa’s research put this theory to the test. Looking at credit spreads and bond price data relative to cash flows and risk premiums, he sought to determine whether variation in spreads between 1973 and 2014 was due to overly optimistic investors providing too much credit to borrowers, or overly pessimistic fund managers providing too little.

Although risk premiums for corporate bonds did fluctuate with market cycles, falling low during booms and rising during recessions, Nozawa found that narrow credit spreads during booms “reflect lower market risk exposure, implying there is no evidence for pronounced mispricing then.”

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Even high-yield bonds, which come with higher risk and can be more difficult to trade in downturns, displayed no strong evidence of mispricing, according to Nozawa.

“It seems premature to conclude that low credit spreads prior to recessions are solely due to the mispricing of bonds caused by the over-supply of credit,” he said.

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