Something very odd is happening in the bond markets. At a time when risk aversion is at the forefront of investors’ minds, they are piling into junk bonds in such volumes that they have squeezed yields down by around a third since October 2002.
That means that they are paying to take on risk – a peculiar strategy when they are abandoning the risky equity markets.
Confused? You should be, because one of the strangest aspects of this is that the forces producing this trend are contradictory.
New research from RiskMetrics, a New York-based risk analysis firm, shows what many market participants may have suspected for some time. Based on data drawn from thousands of different bonds, the analysis creates yield curves based on the credit rating of the underlying assets. The data covers US bonds only, but the pattern is likely to be repeated elsewhere.
The graph based on this sets the risk-free investment rate as zero and plots the securities’ premium over that. And the results are striking, with the yields on riskier credits shrinking rapidly.
“This story is starting to get people really concerned,” says Mike Thompson, risk analyst at RiskMetrics. That is because all this could mean either of two things. First, it could mean that this is a bubble, generated in part by investors getting out of equities and into bonds. As part of that, they are grabbing the most yield they can, driving down yields on high-risk credits, which is relatively easy given the thin liquidity in these instruments. These investors clearly don’t envisage an upturn in the equity markets any time soon – they think interest rates are low for a good reason, and that they will stay that way.
On the other hand, what the figures may demonstrate is that investors are betting on a fundamental economic recovery. These investors see the recent small upturn in the equity markets as evidence that a recovery is on its way. They are buying junk bonds in the hope that this recovery will drive up demand and yields on these securities in future.
One of these groups of investors simply must be wrong. “Investors have the starkest choice,” says Thompson. “They have to choose a directional curve. Either they are for a recovery or they are not.” Some investors swing one way, and some swing another. Others, according to Thompson “see the figures, scratch their head, see that both sides of the argument are plausible, and don’t know what to do.” But they have to do something. “It is hard to stay neutral and even harder to make a directional play.” Thompson adds.
But while Thompson can see what some investors may be doing wrong, he doesn’t know what else they could do. “If you pinned me against a wall I would say look for something in convertibles,” he says. It is a reluctant, and not particularly positive suggestion. “Investors have to be looking at all the information that is out there and find a way of convincing themselves into taking a view, as painful as it seems,” says Thompson. “And if you are wrong, take your losses and run. We are in a period of sharp turnarounds and long trends.”
