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The Eccles Building, housing the main offices of the Board of Governors of the Federal Reserve System in Washington, DC. Photo: Getty Images

Bond Markets Just Waking Up to Their Own Craziness

WT24 Desk

The bond market has been turned on its head by central banks—and the market’s tantrum shows it, WSJ reports

Last week brought a string of events that could be read as clear signals of overheating in credit markets. There was the bizarre sight of French drugmaker Sanofi and German consumer-goods company Henkel issuing debt at negative yields. And in the European high-yield market, bearings maker Schaeffler and packaging group Ardagh sold large payment-in-kind notes where interest can be paid in additional debt under certain circumstances, traditionally a sign of a frothy market. Yields on “junk”-rated euro-denominated debt hit a record low of 3.35% last week.

Yet it was a selloff in risk-free government-bond markets that caused turmoil as inaction by the European Central Bank and the looming U.S. Federal Reserve meeting led investors to fret about the end of easy money. Traditional signals of risk aren’t as reliable as they might be in markets that have been so distorted by central-bank policies.

Take the developments in junk bonds. Ultralow yields and issuance of PIK notes might usually suggest a market that is too bullish for its own good. Demand was so strong for Schaeffler’s sale that it was able to sell €3.6 billion of debt in euros and dollars, versus an originally planned €2.5 billion; in the process it refinanced debt that carried rates ranging from 5.75% to 6.875% with notes paying from 2.75% to 4.75%. Moreover, in Ardagh’s case, some of the proceeds were used to pay a dividend to shareholders, another sign that borrowers have the upper hand.

But equally, the high-yield market doesn’t feel frothy on its own, and issuers are far from fully exploiting these conditions. Issuance in aggregate in Europe is actually sharply lower this year, even as borrowing conditions have improved: year-to-date high-yield sales are running at €39 billion, down some 40% on the same period of 2015, according to J.P. Morgan. The feeding frenzy seen in high-yield markets before the global financial crisis is absent. High-yield spreads are far from record territory.

The real risk lies in investment decisions being made on the basis of ultralow and negative government-bond yields. If they were to rise further, then the ripple effects could be large. There is some cushion for riskier assets in their relatively higher yields, but not enough to compensate for a sharp rise in underlying rates. Still, it is the foundation that markets are built on that looks most wobbly.

The odd outcome is that at least initially, the pain in bond markets is felt most quickly and acutely in “risk-free” assets. On Friday, German government bonds lost 0.69%, while euro-denominated investment-grade corporate bonds returned minus 0.28% and euro high-yield bonds minus 0.23%, according to Bank of America Merrill Lynch indexes.

Central banks have created a world where government and corporate borrowers have never had it so good. But investors have never had it so confusing.

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