The developed world remains mired in the debt crisis that roiled the global economy in 2008. Growth is low, and deleveraging is an ongoing process. However, the response by policymakers has been strong, and free money is leading to bubbles, the misallocation of capital and excess leverage. In this note, we lay out a framework and road map for investors to look at the rise and inevitable bursting of the bubble in global corporate bonds. The Fed and the rest of the G4 central banks have created a bubble in the corporate bond market.

Company borrowing has surged, and corporate bonds outstanding in the US now outnumber mortgage-backed securities. At the end of 2012, there was $8.6 trillion worth of corporate debt outstanding which compares to $8.2 trillion in mortgage-backed securities (please click image for larger view).

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It is only reasonable to expect the next crisis to hit will materialise in the (global) corporate bond market and that future QE programs and liquidity provisions will involve corporate bonds. The yield on corporate bonds in many cases is so low that investors are not even being  compensated for the probability of default based on historic default rates. Yield is now being sought in all corners of the world without consideration of underlying risks. As long as yields are higher than the benchmark (which is ZIRP), any yield is attractive. Using a metaphor originally coined by the Economist’s Buttonwood, yield-hungry investors are now picking up dimes in front of the proverbial steamroller. The merits of aggressive central bank monetary policies can be debated, but the effects are certain.

In the US, a new credit cycle has started outside mortgage creation, and the real question is how far this cycle will go and when it will end. Given the historical relationship between credit growth and volatility in the US, our indicators would suggest that we are on the verge of a new volatility cycle in the US.

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