Battered by Uncertainty, Global Bond Markets Are Acting Strangely

In the US, yields on speculative-grade corporate bonds fell below yields on speculative-grade corporate loans, despite loans’ higher standing in the capital structure. Meanwhile, in Europe, corporate bond issuers successfully raised bonds at negative yields, upending the normal functioning of capital markets. Why are global bond markets behaving so strangely? The answer appears to lie in a volatile combination of ongoing extraordinary monetary policies and broader economic issues.

US capital markets are thriving, but risks remain

At the end of April, US corporate junk bonds rallied strongly, to the point where their yields fell below those of comparable speculative-grade corporate loans – an unusual situation. Loans sit above bonds in the capital structure and are therefore more likely to be paid in the event of bankruptcies. As a result of this higher-priority ranking, yields on loans are generally lower than those on comparably rated bonds.

This anomalous bond pricing raised eyebrows in US capital markets, with market observers generally attributing it to a combination of the Federal Reserve’s decision to pause its rate tightening cycle and the ongoing strength of the US economy.

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The Fed’s change of heart on interest rates made loans’ floating coupons less appealing – without rising rates, investors won’t enjoy rising interest payments. Simultaneously, the rude good health of the US economy eased investors’ concerns about the risk of US corporate defaults, further undermining the case for more-secure loans.

However, in the wake of this market anomaly, some are wondering about the long-term outlook for capital markets, given the atypical combination of a growing but fragile domestic economy, a long-in-the-tooth bull market, stretched asset prices, weakening global growth, and relatively supportive monetary policy.

At this point in the economic cycle, rates would typically be slowly rising. However, the current US expansion has been unusual in that it has been very long, but not very strong. Sustained but moderate growth has kept inflation low despite years of near-zero interest rates. These low yields have pushed investors into riskier assets, including speculative debt, leveraged loans, equity, and other, more-exotic instruments.

Now, strains such as rising trade tensions and slowing global growth have some worrying that a downturn may be around the corner even as many economic indicators continue to paint a rosy picture.

In this uncertain environment, every piece of news has the capacity to jolt markets. The Fed’s unexpectedly dovish March rate decision – policymakers unanimously decided to hold rates steady and indicated there would be no additional hikes in 2019 – sent shivers through the market, as did the news that the Treasury yield curve had inverted.

Treasury yields have moved erratically throughout May as conflicting job, inflation, wage growth, and other data have fueled ongoing ambiguity. More pricing anomalies may lie ahead as markets grope for a clear direction.

Trouble ahead for European capital markets?

In Europe, capital market participants are also observing an anomalous circumstance, albeit a very different one: In the first quarter, two French companies both raised bonds with sub-zero rates.

Today, these notes are both trading at negative yields – investors are effectively paying the companies for the privilege of lending to them. This is a highly unusual situation, although it’s not unheard of.

For several years, certain high-quality European government bonds have been trading at negative yields. But in recent months, the proportion of eurozone government debt with negative yields has ticked up, rising above $10 trillion (€9 trillion) – its highest level since 2016. Negative-yielding instruments now include various maturities of German, Irish, and Swedish debt.

At the same time, as the French corporate notes show, negative-yielding corporate debt is rematerializing. This is a phenomenon first seen in 2016, which was dismissed at the time as a temporary issue driven by the European Central Bank’s corporate bond-buying activities. Its reemergence suggests that the ECB’s monetary policy and other activities continue to distort normal capital market behavior.

This situation, coupled with rising concern about European economic growth, seems to have convinced investors that even the negative yields available on certain government and corporate debt instruments are better than the yields they’ll get holding cash. And for many, buying negative-yielding corporate debt makes sense because they may be able to sell those instruments at a profit when yields fall even further.

With no end in sight to Europe’s combination of slow or negative growth and ultra-low rates, it looks like negative yields may become a troubling new normal for bond markets.

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