(Sept 4): I recently read an article by a popular economist that has a chart showing how European junk bonds are now paying about the same yields as US Treasuries. I have reproduced the chart here (see Chart 1).
The economist goes on to say that the global financial system is out of whack. And this must mean that investors are being overly complacent and that calamities are about to strike.
That narrative was further reinforced by an article on Bloomberg’s website titled “Junk Yields Lining Up With Treasuries Sign of Bubble for BofAML”.
In fact, the Bank of America Merrill Lynch strategists were among several calling for scaling back exposure to euro junk. I am sure you can find a lot more similar writings.
It is scary stuff to read and the chart does tell a frightening story. After all, how can European junk bonds be of the same risk as US Treasuries? (The 10-year Treasury yield is the global benchmark for borrowings and is the closest we have to a risk-free rate.) Is the market really that complacent (in the chase for returns) and the yields convergence an ominous sign?
Here’s what we think. The answer lies in the currency market.
The euro has rallied against the US dollar this year (see Chart 2). There are various reasons for this.
Fears of an imminent break-up of the single currency bloc have receded along with political risks. The economic upturn in the eurozone is broadening out and beating market expectations.
Meanwhile, the Trump administration is mired in controversies and hopes for a quick implementation of his pro-growth agenda are fading rapidly, which is in turn weighing on the US dollar.
High valuations for US stocks have prompted fund managers to shift their allocations into the comparatively cheaper eurozone markets.
I am betting that money (especially from hedge funds) has also flowed into the European junk bond markets, causing prices to spike and yields to drop. Hence, the convergence we see in Chart 1.
Yet, despite falling yields, the trade makes perfect sense for an investor whose returns are denominated in US dollars.
Chart 3 shows the total returns for a junk bond buyer (in US dollar terms) after taking into account currency gains. That is a lot of profit for a very short period of time.
Moral of the story? When you think you are a lot smarter than the market, think again!
Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore
