Risk returns to the bond market
Bond investors have had a bumpy ride of late. The yield on the ten-year US Treasury note has jumped from just under 4% to about 4.5%, pushing down capital values accordingly, while UK and eurozone bonds have also sold off. Fears of resurgent inflation, thanks to a weak dollar and high raw-material prices, along with the recent strong increase in US producer prices, have fuelled jitters. And last week, corporate and emerging market bonds suffered a panic after General Motors issued a profits warnings that could lead to its debt being downgraded to junk status. European investment grade bonds relinquished all of 2005’s gains; junk bonds tumbled; and the spread on the JP Morgan emerging market bond index rose to 0.25% above early March levels. Brazil was forced to cancel a weekly debt sale, while Portugal Telecom withdrew a 20-year debt issue.
Since Alan Greenspan noted last month that low government bond yields were a “conundrum”, bond markets “have gone from conundrum to contagion”, says Mike Monnelly on Breakingviews.com. The uptick in Treasury yields had reduced the appeal of “overheated” corporate and emerging market bonds, but GM’s warning “really made credit investors reassess whether they were underpricing risk”. Note that the company’s problems “were hardly a bolt from the blue”; ratings agencies have been hinting for months that it could lose its investment-grade status.
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So is a collapse in risky bonds on the cards? Much depends on the Fed, says the FT. If interest rates climb gradually, investors will remain tempted by risky assets. But the possibility that inflation may mean steeper rate hikes implies higher-risk premiums across all markets, and that means investors will demand higher yields than they have done recently. And that, in turn, means falling bond prices. This kind of retreat from risk bodes ill for equities, says Lex in the FT. The Credit Suisse First Boston risk appetite index, which measures the performance of a basket of risky assets relative to safer ones, recently moved into the realms of “euphoria” - a risk appetite last seen in March 2000. Of the seven moves into the euphoria zone since 1981, equities suffered a bear market or correction six to 12 months later on four occasions, and stayed flat on two occasions. Cautious “equity investors might want to sit out the next dance”.
