Why the fixed income market is being turned on its head

Home Markets Why the fixed income market is being turned on its head
Why the fixed income market is being turned on its head

When the superstar fund manager Neil Woodford speaks, the market listens.

And this week he has raised concerns about a potentially fatal phenomenon: Euro-backed junk bonds are now trading at such low yields that they are actually cheaper than 10-year US Treasuries.

Yes, you did read that right – high yield (in other words, high risk) Euro-backed bonds are offering lower yields than those of the US government. In fact these bonds have fallen by around 20% since 2009, when they were offering yields of around 25%.

True, this fall in yield might be blamed on the €2.2 trillion of assets currently being held by the European Central Bank (ECB). But junk bond yields have been falling steadily since before the ECB began its massive monthly bond buying programme.

So what’s going on? The truth is no-one really knows. The only answer anyone can give with any confidence is that with Germany offering negative yields on its short-term bunds, the US not far off the same levels, the ECB charging investors to hold deposits, interest rates in Britain at near zero and bond yields again extremely low, investors have shrugged their shoulders and decided their money has to go somewhere.

This week there’s a strong chance we will see further central bank policy divergence which could exacerbate this bond issue. The US Federal Reserve is expected to hike interest rates for the third time this year, while the ECB and Bank of England sit on their hands.

While the ECB has said it will cut back on quantitative easing from January, the Bank of England shows no signs of tightening, while in the US, the Fed has stopped QE and is now looking to return its trillions of asset purchases to the market in such a way that it doesn’t cause an imbalance. All of this will have an impact on the bond market and central bankers are acutely aware of the dangers.

What is uniquely frustrating about the current situation is that it was never the case that there wasn’t enough money in the system. We knew that as far back as 2010 when banks and corporations were accused of sitting on piles of cash. The problem was a lack of confidence.

QE eventually restored confidence, but so much so that some brave souls felt it was worth taking a chance on the riskier bonds out there.

With the increase in demand, even Euro-linked junk bonds were able to offer less attractive yields than they otherwise would have.

In a normal, well-functioning marketplace there should never be much demand for such high risk investments. Clearly we are still a long way off a normal, well-functioning global marketplace, but it may feel in some quarters – though obviously not in Britain – that we are inching back towards normality.

Yet the process of returning to full normality will probably take years, if not an entire decade more.

Those holding such Euro-linked junk bonds will have to time the market very well in order not to suffer huge losses on their investments.

Original Article

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