Is credit the real bubble?

“Talk of bubbles is in the air again,” says The Economist – and understandably so. The Dow Jones Industrial Average has hit a record high, while demand for new initial public offerings (IPOs) – most notably loss-making social-media site Twitter – is robust.

US shares trade on a cyclically adjusted price/earnings (Cape) ratio of 25, significantly above their long-term average. Investors are increasingly confident and it’s hard to avoid the conclusion that many markets look expensive. But a bubble? Maybe not.

“There is nothing like the same excitement about shares that was seen in the late 1990s; net flows into mutual funds only just turned positive this year… CNBC… suffered its lowest audience ratings since 2005 in the third quarter.” In short, while valuations may be stretched, there is little sign of mania.

But while stock markets might just be given the benefit of the doubt, it’s hard to say the same for some other assets. Take corporate credit, says Jeremy Warner in The Daily Telegraph. “With interest rates at rock bottom, lenders are again throwing caution to the wind and lending indiscriminately.”

Leveraged loans – loans to companies that already carry significant amounts of debt – are a greater proportion of new lending than before the global financial crisis. Corporate credit spreads – the gap between yields on corporate bonds and supposedly risk-free government bonds – are at record lows (in other words, investors aren’t demanding much extra yield for taking the extra risk).

Private-equity firms are once again financing deals through high levels of borrowing, while riskier types of debt that offer investors less protection are becoming easier to sell. It’s all symptomatic of a “search for yield” that is encouraging “investors to think of what is essentially junk as comparatively risk-free”.

So far, this willingness to embrace risk has worked out, says Ralph Atkins in the FT, but that’s because “relationships between economic growth, default rates and corporate borrowing costs have been badly distorted”.

Normally, when growth is weak, more firms fail. But eurozone default rates have dropped in the past year despite a recession, because low borrowing costs are compensating for falling earnings. “The big question is: what will happen when central-bank policies return to something more like normal?”

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