This is What it Looks Like When Credit Markets Go Nuts


by Wolf Richter, Wolf Street:

Pricing of risk kicks bucket in record central-bank absurdity.

As the days pass, the perverse effects of central bank policies on the financial markets are getting more and more amazing. This includes the record-setting nuttiness now reigning in the European bond market, compared to the mere semi-nuttiness in the US bond market.

The 10-year yield of US Treasury Securities closed at 2.34{5f621241b214ad2ec6cd4f506191303eb2f57539ef282de243c880c2b328a528} yesterday and at 2.33{5f621241b214ad2ec6cd4f506191303eb2f57539ef282de243c880c2b328a528} today. This is low by historical standards. It’s barely above the rate of consumer price inflation as measured by CPI, which was 2.2{5f621241b214ad2ec6cd4f506191303eb2f57539ef282de243c880c2b328a528} in September. This means that coupon payments barely make up for the loss of purchasing power. If inflation ticks up just a little, bondholders will be left in the hole. And a yield this low doesn’t compensate bondholders for any other risks, including duration risk, which can be significant. In other words, this is a bad deal.

But in this strange world, it looks practically sane, compared to the Draghi-engineered negative-yield absurdity that has overtaken the Eurozone, where the average yield of euro junk bonds – the riskiest bonds out there – dropped to 2.16{5f621241b214ad2ec6cd4f506191303eb2f57539ef282de243c880c2b328a528}.

This chart, based on the BofA Merrill Lynch Euro High Yield Index via the St. Louis Fed, shows how the average euro junk-bond yield (red line) has plunged so far this year, on the way to what? Zero? The 10-year US Treasury yield (black line) has started rising in past weeks and, in late September rose above the euro junk bond yield for the first time ever:

This average junk-bond yield is based on a basket of below-investment-grade corporate bonds denominated in euros. Among the issuers are European subsidiaries of junk-rated American companies. For them, it’s nearly free money.

The nutty thing is this:

These euro junk bonds are rated below investment grade. They have been issued by over-indebted companies with a considerable risk of default. Liquidity is low in the corporate bond market, and it can be difficult to sell the bonds when the selling starts. And unlike the US government, which prints its own money, corporate entities can – and do – go bankrupt.

But the ECB has been buying all kinds of securities, including corporate bonds, in its efforts to push yields down. As yields fall, bond prices rise. And so it has created the largest credit bubble ever.

This started in the summer of 2012, when Draghi pronounced the magic words that he’d do “whatever it takes” the bring sovereign bond yields down. This was designed to save Italy and other periphery states from default. The average junk-bond yield had peaked during the debt crisis at around 11{5f621241b214ad2ec6cd4f506191303eb2f57539ef282de243c880c2b328a528}, and at 25{5f621241b214ad2ec6cd4f506191303eb2f57539ef282de243c880c2b328a528} during the Financial Crisis. By October 2013, it had dropped below 5{5f621241b214ad2ec6cd4f506191303eb2f57539ef282de243c880c2b328a528} for the first time ever.

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