Janet Yellen, the proposed new head of the US Federal Reserve and current vice-chair, gave an accomplished performance in front of the Senate yesterday.

Her well-established Keynesian credentials were evident, and Yellen indicated that she will continue Ben Bernanke's easy money policy.

However, when she was questioned by senators on the issue of asset valuations, Yellen took a stance that raised eyebrows in the markets. She said that there is "limited evidence of reach for yield" and the Fed doesn't see a "broad build-up in leverage".

The reasoning behind the latter statement is understandable - corporate and household balance sheets are in better shape compared with previous periods. But her assertion that investors aren't grasping for yield is clearly debatable.

The performance of the CDS market this year seems to illustrate that investors are going further down the ratings scale, presumably because of the compression in spreads at investment grade level. 'CCC' spreads across the globe have rallied by about 40% since the beginning of the year, while single 'A' spreads tightened by just 14%, according to data from Markit Sector Curves.

The cash market paints a similar picture. Issuance in 'CCC' bonds has soared and yields have fallen, leading many to posit that a speculative bubble has formed. Yellen's view to the contrary may well be right, but there is little doubt that evidence can be found that suggests otherwise.

It seems unlikely that issuers with poor credit quality would find it so easy to sell debt without the excess liquidity created by the Fed and other central banks. If investors feel they are being adequately compensated for risk, then the valuations are justified. But the Fed has already warned banks to limit origination of loans to lenders with weak credit standing, and interest rate exposure is considerable for many issuers.

Yellen acknowledged there were risks to the current policy of QE, and said "this programme cannot continue forever". In response to a question from a senator, Yellen said she would have the courage to pop a bubble. High yield investors will be hoping that time is some way off.

Download full article