Why? First, the quantitative easing (QE) tailwind that has propped up bond prices since early 2009 is beginning to wane.
The US Federal Reserve’s QE2 programme is forecast to end later this month. Few doubt that the Fed, if pushed (and despite current denials), could launch a round of QE3 to counter future economic weakness. On the other hand, the effects of the current round of easing have proved highly contentious.
I pointed out in a blog back in February that the huge spike in commodity prices that we’ve seen over the last year could be traced back almost to the day that Fed chairman Ben Bernanke announced QE2. Although the US government has denied a causal link between its bond purchases and soaring raw materials prices, the undeniable fact is that the last few months have seen geopolitical upheavals of a scale that should make any policymaker think twice before repeating the medicine.
The second reason for caution in bonds is the deepening eurozone crisis. The FT reminded us yesterday that trading volumes in the bond markets of the European periphery have fallen to record lows, even as yields have risen to multi-year highs.
This paralysis is a sure sign that investors are now resigned to the prospect of defaults and are avoiding placing trades in size until the axe has dropped and bonds’ new terms are worked out. And while the FT article suggests that Italian and Spanish bonds so far seem immune from this trend, continuing to trade with healthy volumes, it’s surely too early to sound an all-clear for these markets. After all, deteriorating liquidity in the least creditworthy segments of the structured finance market in 2007 was a sign that problems were about to become much more widespread.
The intertwining of government and bank liabilities—with European banks propped up both by their own governments and by the European Central Bank—is also a reason why default risks could easily spread, and dangerously so.
The final reason for caution is ETF-specific, but is also a direct result of central bankers’ zero interest rate policies and other stimulus measures such as QE. And that’s the sheer volume of investors that have been driven into riskier, yield-seeking areas of the bond markets in an attempt to preserve purchasing power.
While the recent trend for some high-quality corporate bond yields to trade below the yields of equivalent-maturity sovereign paper makes sense, there’s plenty of money that’s flowed into less secure, higher-yielding paper, and via ETFs. And particularly in the US ETF market, I might add.
Deutsche Bank’s ETF strategist, Christos Costandinides, reminded us in a research report released last week that several corporate bond ETFs suffered badly during the 2008 crisis, with some registering discounts to NAV of 5 percent or more. The problems associated with pricing bonds and bond indices (and the ETFs that follow them) haven’t gone away, says Costandinides, and the make-up of those indices is often not as transparent as it should be.
All of these concerns suggest that the bond ETF boom that’s been a feature of the last couple of years may be passing its peak. And with bonds dwarfing equities by some margin in their overall market footprint, that’s a reason for all of us to watch out.