Credit quality is key for yield moves, analysts say
As global stock markets plunged in the aftermath of the “leave” vote in the U.K.’s referendum on European Union membership, investors were looking at the bond-segment of their portfolios hoping to preserve capital and income.
But unlike stocks SPX, +1.19% , which are typically viewed as so-called risk assets—meaning that they rise when risk appetite soars and they tumble at times of fear and risk aversion—bonds are a whole different animal.
Parts of the bond market, such as certain sovereign bonds, including U.S. Treasurys, are traditionally viewed as haven investments in times of market turmoil, while other bonds, such as high-yield bonds, are strongly correlated with the stock market and typically behave like risk assets.
Here are three ways that Brexit could affect bond portfolios:
European sovereign bonds
Sovereign yields tumbled for a second day on Monday, as investors continued to flock to the perceived safety of government debt amid a global stock selloff.
The moves pushed the 10-year yield on the U.K. government bond, TMBMKGB-10Y, +4.71% below 1% for the first time ever. And the yield on Germany’s 10-year bond, known as the bund TMBMKDE-10Y, -11.35% fell deeper into negative territory at minus 0.108%.
But the effect has not been the same between the bonds of the so-called European core—including countries like Germany, France, Belgium and The Netherlands—and the so-called periphery—including countries with lower credit quality, like Greece, Spain, Italy and Portugal.
In fact, as the following chart shows, on Friday, yields moved in the exact opposite direction between the core and the periphery. In Denmark, Germany, The Netherlands, Austria, Belgium and France, yields tumbled whereas in Sweden, Ireland, Spain, Italy, Portugal and Greece, yields rose.
Capital Economics
“If peripheral bond yields were to rise further, they could threaten to reignite the eurozone’s debt crisis and raise fears that a country might be forced off the euro,” Stephen Brown, European economist at Capital Economics, said in a Friday note.
Credit Suisse fixed-income strategists Praveen Korapaty and William Marshall said Friday they expected that certain benchmark yields, such as the yields on the 10-year Treasury, the 10-year bund and the 10-year Japanese government bond, would continue to tumble due to the continuing uncertainty and a “resetting lower” of monetary policy expectations.
However, the strategists also said they expect “European peripheral spreads to widen significantly further from current levels” as “markets are already pricing for higher risks in the southern periphery.”
The growing prospect that these countries in the future could elect governments that could put them at odds with the EU is “a material risk for the medium term,” the strategists concluded.
U.S. Treasurys
Global demand for haven assets has led Treasury prices to soar over the past two sessions, pushing yields to the lowest levels in nearly four years on Monday, as the chart below shows:
Tradeweb
Foreign demand for Treasurys—cited by analysts as the main factor that’s kept Treasury yields at historically low levels—is expected to continue, particularly as yield-starved investors in Europe and Japan have no alternatives, said James Kochan, chief fixed-income strategist at Wells Fargo Funds Management.
In a Friday note, Bank of America Merrill Lynch strategists called U.S. Treasurys “the only game in town.”
Credit Suisse’s strategists agreed, saying that “10-year Treasurys are very likely set new all-time yield lows and remain well supported amid an extended period of uncertainty and persistent volatility.” They recommended buying long-term U.S. government bonds.
Apart from the obvious risk-off flows, there is an additional key driver of Treasurys, the Bank of America analysts said: the flight out of British gilts by risk-averse foreign investors is likely to benefit Treasurys.
This has happened before, the analysts said. In 2011, the large scale downgrade of European bonds—during which Europe’s share of a credit rating of AA2 or higher in the global sovereign index dropped from 84% to 51%—sparked a flight to quality into Treasurys that reduced U.S. yields by about 50-75 basis points.
Corporate bonds
The Brexit vote resulted in a spike in risk aversion and a notable selloff in corporate bonds on Friday. This resulted in rising yields and widening credit spreads, which are the yield differentials between corporate bonds and Treasurys of similar maturities.
Still the effect of the selloff differed significantly between bonds of different credit quality.
High-yield credit spreads widened by 49 basis points on Friday, and ended the week almost 8 basis points wider than prior week’s close, according to data from Janney Montgomery Scott. High-yield bonds, also known as junk bonds, have low credit quality and are considered riskier.
But investment grade credit spreads widened 6 basis points on the day, but ended the week 2 basis points narrower on the week, which reflects that the selloff was not nearly as severe in high-grade bonds relative to junk bonds.
That makes sense, as high-grade corporate bonds from “big blue-chip corporations” tend to become a “buying opportunity” when sovereign bonds yield near zero or below zero, as they are considered relatively safe and offer significantly higher yields that sovereign bonds, said Mike Bailey, director of research at FBB Capital Partners.
The S&P 500 Investment Grade Corporate Bond Index is up 6.3% year-to-date and 1.3% this month, while the S&P 500 High Yield Corporate Bond Index is up 5.4% year-to-date and 0.9% this month.
SOURCE: Market Watch
