Why did bonds see a complete reversal from the previous week?

Market Realist

Huge weekly outflow: High yield bond market outlook (Part 1 of 4)

Quick recap on the week ended January 24, 2014

Investors remained enthusiastic, while issuers sat on the sidelines to watch the market reaction to the Fed’s asset purchase program. Despite high demand from investors and limited new issuance, bond prices fell as yields moved higher. The ten-year U.S. treasury yield was lower. However, the effective yield on the Bank of America Merrill Lynch U.S. High Yield Master II Index (BAML) remained elevated. This was caused by widening in the credit spread, which is a risk premium for corporate bonds. The BAML index is used as a benchmark index for the high yield bond market. Fund flows continue to favor the high yield bond market in anticipation of higher returns.

Last week

The week seems to have brought a change in investor perception, with lower demand (funds flows declined) and relatively higher supply (issuances increased). While both issuances and deals got better on the board than the previous week, these changes were largely offset by the large sell-offs in high yield mutual funds and exchange-traded funds (ETFs). As a result, high yield bond prices increased. The yield on the ten-year U.S. Treasury note fell to 2.6% on January 31, 2014, from 2.7% the previous week—its lowest level since November, 2013.

The Fed announced that it would continue to taper asset purchases by another $10 billion monthly in February, leaving asset purchases at $65 billion per month. Purchases of mortgage-backed securities are now scheduled at $30 billion a month and long-term Treasuries at $35 billion. On top of this, weaker-than-expected economic data are causing volatility in the market. The S&P 500 was trading at the lowest level since October on account of weaker-than-expected manufacturing data and a soft employment market.

  • U.S. non-farm payrolls increased by 74,000 in December but remained below the 196,000 gain analysts expected.
  • The weekly jobless claims data released on January 30, 2014, wasn’t very impressive, with a 19,000 increase in initial jobless claims to a one-month high of 348,000 claims—colder weather is blamed.
  • The mortgage market declined amid the higher home prices and the shortage of supply.
  • The U.S. dollar strengthens against most of the major currencies as an effect of tapering.

Spillover effects on emerging markets

As a result of the Fed’s transition towards a normalized monetary policy, we saw a huge selloff in emerging markets last week as investors fled to safety. While tapering of the asset purchase program remained a concern for emerging markets, other internal factors were also not very impressive. China, one of the biggest emerging markets, posted a decline in manufacturing PMI data (from 50.5 to 49.5), indicating a slower pace of activity going forward. There was a steep drop in the Argentinean peso because the government ran out of foreign exchange reserves, so it couldn’t defend the exchange rate any longer after tapering put down pressure on the exchange rate. In Turkey, the currency also dropped significantly, partially as a reaction to Argentina. The Turkish Central Bank reacted by hiking the overnight lending rate from 7.75% to 12.5%, but the Turkish lyra still remained weak.

Choppy market conditions, together with the Fed’s tapering of quantitative easing, forced investors to withdraw from the high yield bond (HYG) market amid concerns on the rise of the long-term interest rate, while issuers were still capitalizing on the lower yields.

We’ll discuss weekly issuance and fund flow performance for the high yield bond market in the next part of this series. Let’s read on to learn more.

Continue to Part 2

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