THE GOOD LOOKING ONES ARE ALWAYS BAD NEWS
Yesterday, a few different readers emailed to ask my opinion about the European Junk Bond versus US Treasury yield chart that Tiho Brkan from The Atlas Investor Blog recently published.
Well, I have to give Tiho credit, his chart certainly stirred up a lot of primal urgings from investors eager to short European junk bonds. Although I am a huge Kodiak Grizzly of a bond bear, I think there are better ways to express this view than shorting European junk. Let me tell you why.
I couldn’t replicate Tiho’s chart exactly as I don’t pay for the Bank of America / Merrill Lynch bond indexes, but I found a Barclays/Bloomberg index that is close enough. So here is my version.
I also couldn’t determine Tiho’s term for the US Treasury yield in his chart, but it sure looks like the 10 year yield, so I am going with that.
So when comparing these two series, let’s start with the obvious. The current on-the-run US 10 year treasury note has a modified duration of a little less than 9 years. This compares to the European Junk bond index that comes in at under 4 years.
The sensitivity to changes in interest rates will therefore be much higher in the US treasury notes. Comparing these two assets with such different term lengths is a little misleading.
But you might say, “I don’t care - look at past yield levels for European junk! I can afford to have less duration because the credit part will skate me onside.”
And yes, if credit spreads blow out, then shorting junk is much better than sovereigns.
What do I mean by that? When an investor buys junk bonds, they are typically rewarded with an extra yield to compensate for the increased risk. The amount of this extra yield is called the option-adjust-spread, and we can chart it....
...Currently, European junk bonds only offer 2.67% over the equivalent sovereign yield. Wait! How can that be? The US year yield is 2.22% and the two series have recently converged, so that doesn’t seem to make any sense. But you have to remember that 4 year German bunds are yielding negative 42 basis points, so that means European junk bonds are trading at roughly 2.25% (267 bps more than sovereigns).
As you can see from the OAS chart, these junk bonds have often yielded considerably more than sovereigns. During the Great Financial Crisis they spiked to 20% more, and even during the 2011 European credit crisis, they got as high as 10% over.
So yeah, I understand the attraction to shorting European junk. It’s easy to look dreamily at this chart and imagine spreads doubling to 5% without batting an eye.
But there are a couple of problems with this trade....MORE
