There’s little return to be had in European sovereign debt these days. That is, unless, you’re willing to take the risks associated with Greece. In order to get any sort of return from debt on the continent, investors have been chasing poorer and poorer rated bonds, bringing a bounce to the junk bond market on the continent.
The Bloomberg EUR High Yield Corporate Bond Index has increased by more than 2% in the last 3 months, and analysts are expecting the direction to continue. Mathew Cestar, head of European leveraged finance at Credit Suisse, told the Financial Times that he expects a 20% increase in issuance over last year in 2015.
Junk bonds have much higher yield than higher rated debt instruments making them an attractive bet for income seeking investors with nowhere else to put their money. There are also speculators looking to benefit from the expected ECB bet by buying up the instruments in the hope of selling them for a higher price should their predictions come true.
Junk bonds driven by yield
There are two major levels of debt as delineated by ratings agencies like Moody’s and Standard & Poors: Investment Grade and Junk. Junk is anything judged to carry a non-negligible default risk. Investors are usually compensated for that risk with higher returns, but compressed yields driven by expectations of ECB action have thwarted that to a certain extent in recent months.
Junk bonds, almost by definition, yield more than investment grade debt. They are set to attract the money driven from the sovereign market by tiny, or even negative, yields on national debt, and bring performance on fixed income funds up as a result. This path has been followed in the United States in recent years but it will be more extreme in Europe, given the already established effect of the Federal Reserve’s money printing policy.
The ECB isn’t writing a story
Though the story being told may seem clear-cut, the actual movements of the market are likely to be anything but. A lot of prices are pinned on the expectation of an ECB quantitative easing program being launched tomorrow. If Mario Draghi has other ideas, the recalibration through the markets could be substantial. It is also important to take note of the impact of other sectors on bond yields.
At the end of last year the collapse in the price of oil caused a drop in price a wide range of bonds in the US market. Much of that country’s junk debt was driven by risky oil exploration companies that got a whole lot riskier when the price fell. The ECB is not in complete control of junk bond yields, and the stories that investors tell about the market are often incorrect.
Investment banks are betting on that rise in demand, however, and, according to a recent Financial Times piece on the market, several companies are organizing new offerings in the European junk bond market in the months ahead.
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