The Bank of Israel is concerned about the corporate bond market boom and its effect on financial stability, and about the state of the housing and real estate market. In its report on the stability of the financial system, published today, the bank lists the reasons for its concern. The bank does not actually use the term "bubble," but its analysis of the state of this market shows that the bank believes there is a bubble in the markets.

"Returns in the corporate bond market are at a very low level, and concern is growing about underpricing of the risks in this market, because the spreads have continued to narrow, reaching low levels in recent months, similar to those seen in the second quarter of 2008," the report stated.

The Bank of Israel takes specific note of the rises in this market since the beginning of the year, and writes that bond prices are deviating from their true value, with the risk failing to correspond to the spreads, or in plain language, that bond prices are too high.

The bank warns against factors liable to reverse the trend and cause a drop in the market: "An increase in the economy's risk or a turnaround in the interest rate pattern is liable to affect the dynamic in the corporate bond market, and cause a change in the price trend."

The Bank of Israel also warns against low spreads between bonds on the domestic market and on the US market, and the consequences: "The narrow gap between Israeli and US state bonds was 0.5% in May. A change in the US market or the geopolitical risk in Israel (such as Operation Protective Edge, I.A.), or a resumption of the downtrend in the US bond market, is liable to cause a chain reaction in the corporate bond market, especially in view of the fact that the corporate bonds spread between Israel and overseas has become even narrower than the spread in government bonds."

The Bank of Israel is also perturbed by the large-scale capital raising in the mutual funds sector, fueled by the rises in the corporate bond market. "The fear that the spreads reflect underpricing of the bond market risk is supported the rapid capital raising by the mutual funds investing in bonds, a developed that is generating downward pressure on returns," the bank's report stated.

The Bank of Israel also analyzes the sectors in the corporate bonds market, and says that the rising trend in the corporate market is led by the real estate companies, writing, "The ever-narrowing spreads of companies in the real estate sector, whose risk profile ranges from medium to high, is very important for two reasons. First of all, this sector accounts for 40% of the volume of offerings since 2013 and 30% of the total corporate bond market."

The Bank of Israel also addressed the wave of offerings in the market, saying, "An increase in the risk in the bond market is also reflected in the increased weight of unrated and low-rated offerings, and the rising proportion of offerings by companies in real estate, a relatively high-risk sector."

The report discusses at length the state of the real estate and housing market. "The main risk to which the financial system is exposed lies in the housing market, given the banks' large-scale exposure to the construction, real estate, and mortgages sector resulting from the substantial proportion of housing in households' asset portfolio," the report states.

The report goes on to say, "The main risk results from the possibility that a domestic or external shock will occur, leading to a sharp rise in the interest rate, or a recession affecting the borrowers' incomes, and a steep drop in housing market prices. Such a scenario is liable to detract from the banks' capital ratios and profits. Such a scenario is also expected to affect the contractors, and to further damage the banks' results."

The bank also mentions that since mortgages constitute households' principal debt, a problem in the housing market is liable to cause households to rein in their consumption in order to meet their mortgage payments, or because they feel less prosperous, which would affect economic growth. In addition, some of them will have to sell their apartments, a development liable to make the drop in market prices worse.

Published by Globes [online], Israel business news - www.globes-online.com - on July 14, 2014

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