Junk bonds that are still in la-la-land while investors chase returns – the risks are doomed.
By Wolf Richter for WOLFSTRAAT.
The bond market went down on Friday. And that was a good thing for the cries on Wall Street that began to hyperventilate on Thursday, when the ten-year treasury yield, after rising months and accelerating over the past two weeks, has risen to 1.52% since it has tripled. August.
By Thursday, various types of complex industries were falling apart and forced sales had begun. By historical standards, and given the inflationary pressures now underway, yields were still astonishingly low even on Thursday. But Wall Street definitely had a cow.
On Friday, the ten-year Treasury yield fell by 8 basis points, part of the 14-basis point increase on Thursday, closing at 1.44%, still higher than where it was on 21 February 2020 a year ago ago was.
Yields rise as the price of bonds falls, yielding a world of hurt – reflected in bond funds focused on long-term treasury bonds, such as the iShares 20 Plus Year Treasury Bond ETF [TLT]; the price drops by about 16% from early August, after the 3.3% easing on Friday.
The Fed approves it.
The governors of the Federal Reserve spoke in unison about the rise in treasury yields: it is a good sign, a sign of rising inflation expectations and a sign of economic growth. This is the mantra they keep repeating.
Fed Chairman Jerome Powell called the rise in treasury yields “a declaration of confidence”.
Kansas City Fed President Esther George said Thursday, “Much of this increase is likely to reflect growing optimism in the strength of the recovery and can be seen as an encouraging sign of rising growth expectations.”
The president of St. Louis Fed, James Bullard, one of the most passionate pigeons, said Thursday: “With the improvement in growth prospects and inflation expectations, the corresponding increase in the 10-year Treasury yield is appropriate.” Investors demanding higher returns to offset higher inflation expectations are a welcome development. ‘
They all sing from the same page: they are on QE and low rates. But they are going to raise long-term rates, which are starting to hurt the ridiculous foam in the financial markets and the housing market.
The Fed rulings on Thursday morning in support of higher long-term returns – when markets complained the opposite, more QE but focused on long-term to lower long-term returns – probably also helped to unravel Wall Street.
But on Friday, the mini-panic subsided again, and that’s good, because a real panic could change the Fed’s stance.
The 30-year yield fell 16 basis points to 2.17% on Friday, wiping out the jump of the previous three days. This is now where it was on January 23 last year:
The yield curve, measured by the difference between the 2-year yield and the 10-year yield, increased sharply, with the 2-year yield stuck, and with the 10-year yield. On Friday, the spread between the two narrowed to 1.30 percentage points, from Thursday’s 1.35 percentage points, making it still the steepest yield curve for this measure since December 2016.
In August 2019, the yield curve according to this measure briefly ‘reversed’ when the 10-year yield fell below the 2-year yield, which made the distribution negative. The yield curve has since fallen in a very rough way:
And the mortgage rate has finally started to follow.
The average fixed interest rate of thirty years rose to 2.97% during the week ending, as Freddie Mac reported on Thursday. This does not yet include the moves on Thursday and Friday.
The thirty-year mortgage rate normally keeps a close eye on the ten-year yield. But in 2020, they disconnected. When the 10-year yield began to rise in August, the mortgage market simply ignored it, and mortgage rates fell from record lows to record lows until early January, causing the housing market to turn into a super foam.
But in early January, interest rates began to rise, rising by 32 basis points in less than two months – although they have historically remained low.
Note the break in 2020 between the weekly treasury yield of ten years (red) and Freddy Mac’s weekly measure of the average fixed mortgage rate of 30 years (blue):
In this incredibly frothy and overpriced bubble housing market, higher mortgage rates will eventually come to mind a few times.
And it also appears that the Fed approves it. They are not blind. They see what’s going on in the housing market – what risks go along with this type of house price inflation. They just can not say it out loud. But they can increase long-term returns.
Mortgage rates can catch up a bit. The spread between the average fixed mortgage rate of thirty years and the yield of ten years has gradually decreased since the madness of March, being at least 1.37 percentage points since April 2011.
The distribution always returns from the extreme layers, like this, to the average. This can be done in two ways: by mortgage lending rates rising faster than treasury yields, or by mortgage lending rates falling more slowly than treasury yields.
High-grade corporate bonds are starting to feel the pain.
Yields have risen and prices have fallen over the investment grade spectrum of corporate bonds, although yields have remained very low by historical standards:
AA-rated bonds yielded an average of 1.81%, according to the ICE BofA AA US corporate index, compared to the record low of 1.33% in early August (my corporate bond rating fraudster).
BBB-rated bonds – just above junk bonds – have come out of their business over the past two months, averaging 2.39%, according to the ICE BofA BBB US Corporate Index, against the record low of 2.06% by the end of December. They, like mortgage rates, continued to decline until 2020, despite rising Treasury yields.
Litter effects are still in la-la-land, with yields near record lows.
BB-rated bonds – the highest rated junk bonds – have come into being over the past two weeks and the average return has risen to 3.45% according to the ICE BofA AA US corporate index, compared to the record low in mid-February of 3 20%.
The average yield of CCC-rated securities – at the most dangerous end of the junk spectrum with a significant chance of default – barely rose from record lows in mid-February (7.17%) and now hangs at 7.27%. In March, the yield rose to 20%. During the financial crisis, it rose north by 40%.
The Fed smiles at its inception.
The fact that the highest risk bonds are still yielding yields that are close to record lows is a soothing sign for the Fed. This means that financial conditions are still extremely easy. All sorts of high-risk businesses with a crushing income and huge losses – think cross lines with almost no income and losses in the wazoo – can finance their cash burning by issuing large amounts of new bonds to zealous returns that rush, no problem.
So far this year, companies have issued $ 84 billion worth of junk, according to to Bloomberg. At this rate, the first quarter will be the largest in the issuance of junk bonds ever. There is a huge demand for junk bonds due to their higher returns – the risks must be condemned. The yield rush is at full steam. And the total junk market has risen to more than $ 1.6 billion.
For the Fed, this is one of the many signs that credit markets are still super-foaming, even as treasury yields have risen from record lows to still historically low levels. Although he promised to continue QE and not raise rates for a while, it also tells the markets in a unanimous vote that rising Treasury yields in the long run are a sign that the Fed’s monetary policy is working as intended. And the higher long-term returns are taking the foam off the market, including ultimately the housing market, and I do not think that is an unintended side effect.
From crisis to crisis, and even if there is no crisis. Read … Fed’s QE: assets reach $ 7.6 trillion. Long-Term Treasury Yields Increase Nevertheless, Wall Street Crybabies Beep for More QE
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