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The June Funk in Europe's Junk Bond Market
How our analysis prepared for the selloff.

By Nico Isaac
Mon, 15 Jul 2013 17:45:00 ET
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In the wise words of my friend's son's little league coach:  

"You may think your team has improved over the season when all-star player Sam breaks his own batting record...
 
... But you absolutely know it has when two-left-feet Tommy hits a homer."
 
Conventional economic wisdom applies the same logic to the health of bonds. To wit: When demand for "all-star" securities starts rising, so begins the rumbling of recovery. But when demand starts to pick up for the lesser performing junk bond, that's the time to break out the bubbly.
 
Think Europe in Q1 of 2013: Investor interest in all things high-yielding was moving at a swifter clip than Stephen Strasburg's fastball. Here's what unfolded in the first three months of 2013 alone:
  • European junk bond issuance hit $51.1 billion, an all-time record (Dealogic).
  • Yields on Barclay's pan-European high-yield index fell below 5.5% for the first time ever.
  • $2 billion payment-in-kind loans (PIKs) were sold in Europe -- close to the full year record of $2.14 billion in 2007.
 And according to the mainstream pundits, the bases were loaded for a winning junk bond play: Namely, a record-low interest rate environment, continued monetary easing by global central banks, and signs of economic recovery. Consider these headlines: 
  • "There is just a huge compression of yields as global investors continue to chase corporate credit and credit generally. There is a finite pool of assets that can be invested in, and demand is far outstripping supply." (Financial Times)
  • "The extra compensation investors are being paid for holding junk bonds relative to government debt is still in the range deemed fair value." (Associated Press)
  • "Yields have come down but quality has also gone up. I haven't had any taxi drivers telling me to buy high yield bonds; when I do, then I'll be selling." (Wall Street Journal)
 But then came June. Europe's junk bond market struck out as high-yield bond issuance went from a record inflow to a record outflow. And, the cost of insuring European corporate bonds against losses embarked on a five-week-long uptrend -- its longest rising streak in two years.
 
A June 27 Wall Street Journal captures the scene:
 
"A Once Hot Market is Now Among The Worst Performers. There's only so much you can do to defend your portfolio from big corrections like the one we are experiencing at the moment."
 
Actually, there was a safety net in place to ride out this particular correction: EWI's European Financial Forecast.
 
First, the February 2013 European Financial Forecast revealed a time-honored measure of investors' appetite for risk -- and thus, willingness to invest in sub-investment grade assets -- in the spread between low-and high-grade debt: 
 
Credit spreads are a great way to gauge market sentiment because when social mood falls, default concerns rise and the spread between low-and high-grade debt widens. In contrast, credit spreads typically narrow when social mood is rising because bond investors have little to fear of default and therefore feel no reason to be compensated for the extra risk of owning junk. Bond traders mood is clearly nearing an important zenith because European junk bond sales are 'off to their busiest start on record' according to Bloomberg.  
 
 
 
The first panel on the chart shows the spread between Portuguese and Greek bonds (two of Europe's riskiest borrowers) and 10-year German bonds, which are widely considered to be Europe's safest debt. After widening to all-time highs, both spreads narrowed throughout 2012 recently falling to an 18-month low... If our wave count is correct, speculative grade debt is one of the most dangerous bets around.
 
Next, the March European Financial Forecast gave further evidence of a coming junk bond pullback via this chart of 10-year Greek Bond Yields:  
 
 
 
In terms of Elliott waves, the chart also depicts the first tentative signs that Greek yields stand ready to bottom again. The next credit contraction should be underway soon..."
 
And now, the July European Financial Forecast captures the extent of the exodus from high-yield debt with this visual update:  
 
 
 
The 10-year Greek yield bottomed near 8% and spiked 40% to over 11%. While spreads between German two-year bonds and their Irish and Portuguese counterparts also pushed higher.
 
(Editor's Note: The top line on the chart shows the six-fold spike in the equivalent spread between German and the debt of another major Eurozone region. If our analysis if correct, this setup ‘should become one of the most widely followed financial stories in the coming months.")
 
So, what are you waiting for? Find out if the June selloff in European junk bonds is just a blip. Subscribe today and get instant access to EWI's complete European Financial Forecast Service >>
 
If you are already an EWI Subscriber, you may qualify for a discount when you add European Financial Forecast. Log in to MyEWI to see >>
 

 



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