The credit markets have sharp antennae. They issued early warning alerts four to eight weeks before each episode of stress over the last 20 years, although with several false alarms along the way.
The shake-out in the US junk bond market last week had an ominous feel for traders and may finally mark the top of the post-Lehman boom in corporate credit. The exuberant reach for yield is nearing its limits.
“It is a sober moment. People are suddenly aware that central banks are turning serious and are not going to keep creating stimulus ad infinitum,” said Marc Ostwald from ADM.
The metric watched by markets – the Bank of America Merrill Lynch high yield option-adjusted spread – has jumped 40 basis points to 3.8pc over the past two weeks. Blackrock’s iShares HYG fund, the biggest exchange traded fund (ETF) for junk debt, fell to a seven-month low on Friday. The electric power group NRG Energy…
We’re probably entering a bond market bubble. Here’s what to do about it
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Former Federal Reserve Chairman Alan Greenspan recently told Bloomberg that we are entering a bond market bubble in the U.S., and all signs point to yes. In fact, I would add that what was once a safe, stable and predictable investment class is about to be turned on its head, as interest rates rise and values plummet.
Even so, a bond-market bubble is different than a bubble in the stock market or real estate market. These are markets that bubble when the price paid for an investment cannot be justified by the profit the investor will gain. If the purchase price of a condo far exceeds what the investor can charge in rent, real estate prices become unsustainable (as we saw in 2007). If a company’s stock is trading at such a high price that the company can’t realistically generate a return on those investments, stock prices similarly have nowhere to go but down.
During the tech bubble of 2000, investors mistakenly believed that tech stocks were somehow different than any other investments and that profits weren’t needed for stock prices to rise. The market eventually market realized this, leading to the historic 78 percent decline of the NASDAQ composite. All in all, the common denominator in stock, real estate and bond market bubbles is this: Everyone is rushing to the fire exit, but they cannot get out in time.
Ultimately, bond investors face the same result if they do not rethink their strategies now. Interest rates are set to rise again. While holding long duration bonds has long been considered a safe investment strategy, that is no longer the case. The tried-and-true vanilla income strategy of the past is no longer smart or safe. The longer the duration of a bond portfolio, the higher the interest rate risk. Incremental rate increases could exponentially amplify the holder’s loss in purchasing power.
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