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Have bond investors now truly gone mad?
The above image appeared this week in my Twitter timeline. The yield on European high yield bonds, i.e. bonds with a low credit rating, is now equal to the US 10-year Treasury yield. Which understandably begs the question of whether bond investors have lost it.
At first glance, it seems the answer is “Yes”. Why would you invest in the bonds of corporations in a segment of the market that you know is likely to experience at least a few defaults in the foreseeable future, when you could get the same return by lending your money to the US government? But It’s not quite that simple, there are a few other factors to consider.
First, whereas the risk of default is obviously much higher for high yield bonds than it is for US Treasuries (though the possibility the US could default certainly does exist), the interest rate sensitivity, i.e. the duration, of the latter is considerably higher. Roughly twice as high, in fact. That means that rising interest rates have a much bigger impact on the price of US Treasuries. And for the record, I do expect interest rates to eventually rise.
Second, for many investors, a comparison with US Treasuries is irrelevant. It's more important to look at how much additional spread you would get relative to European government bonds, and, in particular, German 10-year bonds, which are considered the key point of reference for European corporate bonds.
The spread on European high yield bonds compared to German 10-year bonds is shown below. While it's not huge, the spread is also a lot less extreme than in the graph above. In fact, in the 2005-2006 period, the spread was even lower due to a remarkably strong economy. So it's mainly the historically high yield differential between US 10-year (2.25%) relative to European (with Germany at 0.45%) government bonds that explains the trends shown in the first graph.
This leaves us with the question of whether the currently low spread on European high yield bonds is justified. I would tend to say, “Yes”. The Eurozone is currently growing at its highest rate in the last six years. Even the less creditworthy corporations are posting sharply rising profits. That reduces the likelihood of default, particularly in the short term. The graph below shows that Europe's default rate is low, considerably lower in fact than in other regions such as the US and the emerging countries. This is reflected in the spreads on European high yield bonds.
So does that mean that investors haven't gone mad at all? I'd say, they aren't totally mad. Despite good arguments for the low spread relative to German government bonds, the total yield still remains extremely low. There's not much to cushion a bad run. If interest rates or defaults rise even a little bit, the return on high yield bonds will quickly drop down to zero. But it's all relative, of course. A reduction in − and a possible end to − the ECB's large-scale bond-buying program, means the future for European government bonds does not look so bright, either.