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Janet Yellen, head of the U.S. Federal Reserve has warned bond investors not to underestimate the risks of losses and of increased volatility in the future, particularly on corporate bonds.
Junk bonds, rated below investment grade, have little cushion against the threat of rising rates. These supposedly “high yield” bonds offer under 5 per cent in the U.S. and less than 4.5 per cent in the eurozone.
As a measure of the reward for the extra risk taken onboard, investors focus on spreads over Treasury bonds. At just over 3 percentage points, the spread has fallen from more than 20 points at the beginning of the financial crisis, according to the Barclays benchmark, but it’s still a full point higher than at its 2007 low.
The narrow spread reflects an assumption of minimal risk of default combined with little reward for the lack of ability to buy and sell as liquidity has dried up. Ms Yellen listed the spread among her concerns, suggesting that she sees potential for higher defaults, or thinks there should be a higher reward for the lack of liquidity.
Yet, according to the Financial Times, the biggest threat comes, not from the tight spread, but from the assumptions built into the government bonds that underlie junk pricing.
Investors already think the Fed will keep rates lower for longer than the central bank’s own forecasts. Ms Yellen’s comments support the doves. But history tells us that central bankers are hard to predict, and markets are poor at anticipating their shifts.
Investors who think Ms Yellen will never spring a surprise need only look at last year’s taper tantrum for a preview of how hard it will be to remove easy money without spooking the bond markets.
Todays Other Top Stories
Learn Bonds: – Coping with the limitations of investment grade bonds. – For risk averse bond investors, the coupons available in most investment grade securities are hardly what one might call robust. So how does the fixed income investor deal with continuing yield starvation and forward bond market rate risk? For many, the answer may be simple – establish a bond ladder.
Boston.com: – Conditions look favorable for muni bonds. – Increasing demand, tightening supply, and expectations for higher rates and inflation should bring better muni returns in the coming years, says Nuveen’s John Miller, Puerto Rico notwithstanding.
Global Post: – Puerto Rico makes all July 1 debt payments. – The head of Puerto Rico’s Government Development Bank said all payments due July 1 on the commonwealth’s general obligation debt and bonds associated with its public power and highway authorities were made as scheduled on Tuesday.
Vanguard: – Munis versus taxables: Calculating the taxable-equivalent yield. – In this brief video, Vanguard fixed income experts Daniel Wallick and Chris Alwine address municipal bonds, focusing on audience questions from a previous live event concerning the role munis can play in diversifying a portfolio.
Businessweek: – Biggest high-yield muni ETF falls on Puerto Rico concerns. – The largest exchange-traded fund that tracks the riskiest municipal securities fell the most in a year as investors sold on concerns that downgrades to Puerto Rico and its agencies may threaten their solvency.
Market Realist: – Must-know: What is an exchange-traded fund? – In this series, we’ll introduce you to the concept of exchange-traded funds (or ETFs), their types, and their benefits. In addition to discussing the advantages of investing in ETFs, this series gives a comprehensive view on the trends and scope of the U.S. ETF market.
Art of Thinking Straight: – What are municipal bonds? – What are municipal bonds and how are they different from conventional corporate or high yield bonds.
Businessweek: – No bonds left behind in rally except coal-producer debt. – The almost 6 percent rally in U.S. company bonds this year has left the coal industry in the dark.
Investors.com: – Treasuries, other taxable bonds, munis rose In Q2. – Like Goldilocks tasting the little bear’s porridge, fixed-income investors in the second quarter found the economic news not too hot, not too cold, but just right!
4Traders: – Treasury bonds sell off on jobs data. – Treasury bond prices sank Thursday as the latest employment report brightened the outlook for economic growth and reduced demand for safe assets.
Investment Grade Bonds
Traders Magazine: – Corporate bond platforms prep for ugly exit. – Although trading has historically been bilateral and relationship-driven, some see corporate bond market conditions ushering in electronic trading in levels that proponents have long anticipated.
Larry Swedroe: – Does taking corporate credit risk add value? – Don’t be tempted by higher yields because there are more efficient ways to take on risk. The lower a bond’s credit rating, the higher it’s correlation with equities. It’s essentially equity risk in disguise. Higher-yielding bonds don’t make the most effective diversifiers, and they tend to make worst-case losses even worse.
High Yield Bonds
S&P Capital IQ: – High yield bond issuance hits record in June, as yields reach new lows. – Issuance hit a record in June as yields hit new lows, leading more opportunistic issuers to come out to take advantage of attractive rates and ongoing demand. The yield-to-worst on the S&P U.S. Issued High Yield Corporate Bond Index reached a 13-month low of 4.77% in late June, as the yield on the 10-year Treasury held in a 2.52-2.64% range for the month.
Financial Post: – A better kind of junk: High-yield corporate bonds. – The Financial Post takes a weekly look at tools and strategies that will help make your investment decisions. This week: short-duration, high-yield corporate bonds.
IFR Asia: – Boom time for high-yield bond market. – The high-yield bond market is on track for a strong second half following a better start to 2014 than anyone expected in both volumes and returns, thanks to lower underlying rates, a compression in spreads and a rebound in M&A.
ETF Trends: – EM bond ETFs firm as issuance soars. – Helped by declining Treasury yields, fixed income exchange traded funds holding emerging markets debt have been solid performers this year, rebounding from a disastrous 2013 that saw investors flee the asset class.
Citywire Global: – Legg Mason to double EMD threshold in star trio’s bond fund. – Legg Mason is seeking approval to increase the amount of emerging market debt in its $1.2 billion global bond fund overseen by three Citywire AA-rated managers.
Reuters: – Who’s hunting yield in bond market’s risky regions? – The hunt for yield in an era of diminishing interest rates has lured investors into ever riskier regions of the bond market, prompting some to ask: who is buying this stuff and are they suffering short-term memory loss?
Dividend Channel: – This stock has a 6.61% yield and sells for less than book. – BDCA Venture (NASDAQ:BDCV) has been named as a Top 25 dividend stock, according the most recent Dividend Channel ”DividendRank” report. The report noted that among the coverage universe, BDCV shares displayed both attractive valuation metrics and strong profitability metrics.
PIMCO: – Why bonds are still important. – Learn a few simple reasons why bonds still are important part of a portfolio, even when rates are low.
BlackRock: – Is now the time to seek inflation protection? – As unrest in the Middle East pushes oil prices higher, and indicators like the consumer price index (CPI) show signs of an improving economy, many investors are wondering: is now the time to build more inflation protection into my portfolio? Matt Tucker weighs in.
ETF Trends: – How one strategist uses core bond ETFs. – Boston-based ETF strategist Newfound Research, which launched earlier this year, runs a bond strategy aimed at achieving the same diversification and stock hedging exposure offered by long-dated U.S. Treasuries while mitigating interest rate risk.
30s seem to have a hard time getting through the 3.5% level
— Ed Bradford (@Fullcarry) July 3, 2014
Still likely that FOMC QE buying ends @ October 28/29 mtg — but outside chance for September 16/17 with two more very strong jobs reports.
— Bob Brinker (@BobBrinker) July 3, 2014
*RETIREE HEALTH PREMIUMS PROTECTED, TOP ILLINOIS COURT RULES, COMING AMID PENSION REFORM SUITS
— Brian Chappatta (@BChappatta) July 3, 2014