Federal Reserve Governor Jeremy Stein warned about the signs of overheating in the bond markets during a speech in a symposium in St. Louis, Missouri. Stein raised his concerns saying some sectors in the financial system are becoming risky particularly the bond market because of low interest rates. Stein said he is troubled by the possibility of a bond bubble

Jeremy Stein

According to Stein, there is no threat in the wider financial system; however, he observed overheating in several areas of the credit markets including junk bonds, real estate investment trusts, and commercial bank’s securities.

Stein emphasized that there are “fairly significant” patterns that investors in corporate credit markets are becoming more risky. According to him, data showed the existence of a record-high volume of junk bonds issued by low-rated borrowers.

Last month, Lloyd Blankein, CEO of Goldman Sachs (NYSE:GS) stated  that the risk of a bond market collapse is increasing. He noted that investors are not prepared for the situation. He  also advised investors to increase their level of borrowing to benefit while interest rates remain low.

“One lesson from the crisis is that it is not just bad credit decisions that create systemic problems, but bad credit decisions combined with excessive maturity transformation. A badly underwritten subprime loan is one thing, and a badly underwritten subprime loan that serves as the collateral for asset-backed commercial paper (ABCP) held by a money market fund is something else–and more dangerous,” Blankein said in his speech.

Stein also noted the rapid increase of investments in the mortgage real estate investment trust (REIT), which are funded largely in the short-term repo market. REITs buying of agency mortgage-backed securities increased from $152 billion by the end of 2010 to $398 billion by the end of the third quarter of 2012.

According to Stein, the ability of REITs to generate current income depends on the MBS market and repo market. If, the MBS yield declines or the rate of the repo market rises, REITs income will drop.

He also observed that the maturity of securities in banks’ available-for-sale portfolios is near the upper end of the historical range.  He noted that added interest rate exposure provides risk for the banking sector and needs to monitored carefully since the existing capital regulation does not address risk in interest rates.

Stein urged policy makers to respond to the emerging signs of overheating in the credit markets.  “Policymakers should follow a decoupling approach. That is, monetary policy should restrict its attention to the dual mandate goals of price stability and maximum employment, while the full battery of supervisory and regulatory tools should be used to safeguard financial stability,” he said.

In addition, he said emphasized that if overheating in the credit markets build-up in the absence of a firm monetary policy, the federal government might need to tighten credit. “Despite much recent progress, supervisory and regulatory tools remain imperfect in their ability to promptly address many sorts of financial stability concerns,” he said.

The current credit policy is not tight as the primary objective of federal government is to reduce the unemployment rate.