Weekly Update

When Yield Spreads Get Crazy

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Published August 11, 2017


Yield spreads provide a view into the risk appetite of market participants. If the spread between low risk and high risk bonds is large, investors are concerned and want to receive more compensation for taking on the added risk. As investors become more comfortable with the market and begin to view it as increasingly benign, they require less compensation. In times of extreme market complacency, the relationships between risk and return appear to almost break down. And so it is with European high yield (aka “junk”) bonds today.

“The scariest chart in the financial markets right now is European high yield (junk bonds) relative to the yield of U.S. Treasuries,” financial blogger Tiho Brkan writes, offering Chart 1 below as evidence.

Chart 1: Euro Junk Bonds Yielding Similar to US Treasuries

Euro Junk Bonds Yielding Similar To US Treasuries

“As investors go ‘kookoo’ for risk assets, they have pushed (with the help of the European Central Bank) the yield of European junk bonds towards that of the U.S. Treasury yield. Honestly… I’m speechless,” Brkan adds.

Chart 2 shows the tumble in European bond rates which accelerated after the European Union’s crisis in late 2011.

Chart 2: Euro Junk Bond Yields on the Way to Zero?

Euro Junk Bonds Yields on the Way to Zero

How does this fit into the overall scheme of things? For example, compared to the US Treasury yield? US Treasury securities are considered the most liquid and the most conservative investments. They’re considered as close to a risk-free financial instrument as you’re going to get on this earth. Turns out, from November 2016 until now, the 10-year US Treasury yield has ranged from 2.14% to 2.62%, comfortably straddling the current average euro junk bond yield of 2.42%

Back to our chart on the interest rate spread, this time from a different source and notated slightly differently. Chart 3 shows the BofA Merrill Lynch Euro High Yield Index (red line) and the 10-year Treasury yield (black line). Note how they used to be worlds apart, and how the spread between them blows out when investors suddenly see risks again, with junk bond prices plunging and yield surging, while Treasuries barely quiver:

Chart 3: Euro Junk-Bond Investors Go Nuts

Euro Junk Bonds Investors Go Nuts

If you want to earn a yield of about 2.4%, which instrument would you rather have in your portfolio, given that both produce about the same yield, and given that one has a significant chance of defaulting and getting you stuck with a big loss, while the other is considered the safest most boring financial investment out there?

Is the market really so unconcerned about the risk of European junk bonds? Yes and no. The compression in spreads comes from an abundance of money chasing a particular asset. With money seeking yield in any form, and junk bonds offering more yield than other environments, cash has flowed heavily to these bonds thus pushing their interest rates lower. That brings the spread tighter and sets the market up for a rude shock when investors are suddenly reminded of the risk of the asset, which they invariably will be.

Market Update

Stocks kicked off the week with a listless session Monday while large-cap tech stocks pushed the Nasdaq higher by +0.5%. Stocks pushed a touch further into record territory Tuesday morning before succumbing to headlines that President Trump upped the war of rhetoric with North Korea. Stocks fell back -0.2%. They continued the dip Wednesday with another losing session albeit only slightly so. Sellers hit the gas pedal Thursday with the U.S.-North Korea jawboning taking on a more severe (and nuclear-tinged) tone. Stocks slid -1.5% while the volatility index spiked almost +50%. Volatility measures had been riding historic lows until the Thursday spike with markets generally overdue for the cleansing of a strong day of selling. Volatility remained high Friday as investors sought protection from any tense weekend words with North Korea. Stocks managed to shake off the concerns to deliver a modestly positive day with the Nasdaq rising +0.6%.

The S&P 500 (SPY) gave back -1.33% for the week but saw selling hold up at the 10-week/50-day moving average. Small-caps (IWM), on the other hand, tumbled all the way to their 200-day moving average in a -2.67% slide to all but erase their gains for the year. The Nasdaq 100 (QQQ) remained the strongest of the indexes with a -1.08% loss.

Warm wishes and until next week.