Sated Appetite

February 26th, 2016 7:04 am | by John Jansen |

Via WSJ:
By Richard Barley
Feb. 26, 2016 5:49 a.m. ET
0 COMMENTS

The search for yield ain’t what it used to be.

Investors have had a seemingly insatiable appetite for risky securities in recent years, boosted by central bankers wielding ultraloose monetary policy. Now there are signs of indigestion.

The problem is that lower bond prices and higher yields can be as much a warning sign as a tempting proposition. That was the case, for instance, during the eurozone debt crisis, until investors were persuaded that widespread defaults and the collapse of the euro would be prevented.

Take the recent blowup in European subordinated bank bonds. The turnaround has been such that bonds that looked attractive with a yield of 6% last year ended up looking ugly at a yield of 8% or more. That sounds paradoxical. But investors have reappraised the risks attached to these securities—of coupons going unpaid and issuer options to redeem going unexercised.

Another example is in the disconnect between yields on government bonds and on comparable corporate securities. Barclays ’ U.S. corporate investment-grade index, for instance, is sporting a total return of 1.2% so far this year. But that is entirely due to the rally in Treasurys: the excess return on the index, or the contribution from the credit exposure in these bonds, is minus 2.86%. The gap between Treasury and corporate yields, or the spread, has widened to 2.01 percentage points from 1.65 at the start of the year. Lower government-bond yields are no longer reliably dragging corporate-bond yields down with them.

In some ways, this is strange. The conditions that generated the search for yield are still in effect. Central banks like the Bank of Japan and European Central Bank are still on the path of easing policy. With safe-haven instruments offering low returns, the pressure on investors to buy corporate bonds and equities is still significant.
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The big potential problem is the clash between monetary policy and the credit cycle, which is most visible in the U.S. The Federal Reserve has only just started raising interest rates—and already the market believes it should pause—but the U.S. credit cycle is well advanced. Defaults are set to rise, driven by the problems of the energy sector. U.S. blue-chips have been borrowing to reward shareholders through financial engineering by buying back stock and indulging in acquisitions. Looser monetary policy can paper over a lot, but credit deterioration is hard to ignore.

That may be one of the real roots of concerns about the efficacy of monetary policy. It isn’t that central bankers are out of ammunition—ECB President Mario Draghi can surely be relied upon when he says he won’t “give up” on trying to achieve his mandate. It is that the ammunition is no longer proving effective.

Investors still need yield—and this turmoil will provide opportunities to buy some unfairly beaten-down bonds. But the indiscriminate hunger that drove markets to their peak is most likely over.

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