November saw a sudden spree of sell-offs in the fixed income market. Here is a quick look at why it happened, how the market reacted to it and what we learnt from it.
November has been an exceptionally volatile month for the bond markets and, to be specific, the worst quarter since 2011 for high-yield bonds. The spreads have been widening for almost two and a half months now. When this kind of volatility strikes, it is bound to create some nervousness for people who invest in the bonds for safety and stable returns.
The red wave
Since the spreads suddenly widened, there is no place to hide. All fixed income classes and bond investments are suffering, and the markets are painted red. Reports predict that the credit markets are set for one of the worst years since the global financial crisis. Both high-yield (HY) and investment-grade (IG) notes are headed for losses, in euros and dollars, and records say that this will be the first time that all the four asset classes will post a negative return since 2008.
The reasons for the volatility are driven by weak macro and global growth worries. The fear of European Central Bank (ECB) ending its bond-buy program has also pushed spreads a lot wider.
There are worries around the central bank’s interest rate policy going forward. However, we at Evli believe that ECB will keep short-term rates below 0% at least until next summer. The negative ECB rates will provide some stability to the investors. The “search for yield” will return in the short-end as investors would need something with a positive return. This could mean that the short-dated corporate bonds will snap back quickly. Also, like so many times before, market sell-offs start suddenly but they end as abruptly and turn to a market rally.
Currently, there is a defensive mindset in the market. Investors are switching focus towards avoiding losses rather than chasing yields. Even in such grim situations when all are losing, some have suffered less than the others. For instance, like in all sell-offs, high-yield performed worse than investment grade.
But the brutal sell-off means that spread levels are above long-term median levels, especially in the high-yield, which means that for a long-term investor the spread levels as well as the absolute yields are starting to look very lucrative again. Nobody knows when the market turns, but we are definitely closer to the bottom than the top.
For investors currently invested in low yielding, long duration government bonds, the similar duration investment grade market starts to look as an interesting alternative again after the sell-off. Much of ECB’s forthcoming actions are discounted and, in many cases, yields are now again at interesting levels. But at this stage of the economic cycle, you have to do your bond picking wisely as all that glitters is not necessarily gold.
Another interesting thing to observe here, especially for Evli, has been the Nordic bonds. They have performed better than both investment grade and high-yield bonds.
Although usually considered riskier, it has been observed even in the past that the Nordic bond market tends to perform better when other European markets are in a turmoil. We saw a similar trend earlier this year as well. During the political crisis in Italy, the effects were felt in the corporate market across Europe while the Nordic market remained calm.
The better performance can be credited to the fact that Nordic bonds have shorter maturity periods and the companies are in good financial health. Also, another important factor is that the exchange-traded funds (EFTs) that tend to have a very cyclical investor base are not present in the Nordics. This has given the Nordic bond market a more stable investor base.
Also, some investors question the liquidity in the Nordic bond market during a sell-off situation. But the market has been fully functional during November.
During the worst days of investment grade and corporate bond segments, they had sellers only. However, in Nordic bonds, there were buyers all the time as well. Interest was seen in two ways in the market, which is a very good sign for liquidity under distressed market conditions.
All this is just another revalidation of the Nordics being a stable bond market.
Text: Mikael Lundström, MSc (Econ), Chief Investment Officer at Evli. Mikael has invested in the European High Yield market since it’s birth in 1999 and has been the portfolio manager of Evli Corporate Bond fund and Evli European High Yield fund since launch. He holds a Morningstar Analyst Rating for his funds.