High-yield bond funds: Love them or leave them?

29 May 2015 | Author: | No comments yet »

Is the spread between the Treasury and the bund unsustainable?.

Just when it looks like the yield on the 10-year U.S. government bond is ready to shoot up like a bottle rocket on the Fourth of July, it comes crashing down to earthly levels near historic lows.

In early New York trading, benchmark 10-year notes gained 6/32 in price to yield 2.109%, according to Tradeweb, dragging the yield to its lowest in three weeks.Treasuries rose, pushing the 10-year note yield to a three-week low, as revised data showed that the U.S. economy shrank in the first quarter, signaling that the Federal Reserve’s path to higher interest rates is uneven.Though there have been conflicting explanations as to why eurozone bonds sharply sold off in recent weeks— including low liquidity, a temporary lack of supply and improving fundamentals in the eurozone—one thing is undebatable: the sharpest three-week German rise in German yields since 1990 spilled over to global markets, affecting U.S. While there were renewed signals from the central bank that it plans to raise interest rates this year, traders aren’t predicting more than one increase anytime soon and a Morgan Stanley index suggests policy makers won’t act until December.

Treasuries have expanded their yield premium to German government securities, adding to the allure for overseas investors. “Investors sense the rout the Treasury market suffered was mainly technical in nature and represents a fairly decent buying opportunity,” said Christopher Sullivan, who oversees $2.4 billion as chief investment officer at United Nations Federal Credit Union in New York. But even with the Federal Reserve getting ready to pull the trigger on its first short-term interest rate increase since 2006, and pundits continually pointing out there’s no reason for bonds to be trading as if the world is coming to an end, bond investors keep buying U.S. government bonds — pushing yields down.

That fueled demand for safe-haven bonds, adding to existing gains Friday morning driven by month-end buying as money managers look to square their positions with new bonds that are worked into their benchmark bond indexes at the close of each month. “The passing of [an as-expected gross domestic product report] did indeed incite some month-end buying,” says Daniel Mulholland, senior US Treasury trader at Crédit Agricole. The spread between the yields of the benchmark 10-year Treasury note TMUBMUSD10Y, -1.84% and the 10-year German bond, known as the bund TMBMKDE-10Y, -7.33% was recently at its widest level in 15 years. Given the historically large extension, “there’s no doubt that the market should stay better bid between now and 3 p.m.” CRT Capital’s government-bond strategists said month-end demand from overseas helped 10-year and 30-year Treasurys outperform, adding that “the momentum should carry us into the weekend.” Earlier Friday, the Commerce Department’s second take on economic growth last quarter showed a 0.7% contraction, which is a bit better than the 1% shrinkage economists had expected. But while the Fed and investors are pinning most of the first-quarter weakness on transitory factors, analysts say incoming economic data need to support expectations for a spring rebound for Treasury yields to climb higher. “While the sticker shock of a negative 1Q GDP print [result] could prove supportive to Treasurys,” other more up-to-date data will help shape Fed policy expectations, said Gennadiy Goldberg, a U.S. strategist at TD Securities. Either rising growth expectations supported by economic data in the eurozone will spur a selloff in European bonds, pushing yields higher; or the yield-differential trade will spark buying of U.S. government debt, driving Treasury yields down.

Excluding Friday’s gains, the Treasurys market has handed investors a total loss of 0.38% this month, through Thursday, reducing the year-to-date total return to 0.72%, according to Barclays. A swelling trade gap subtracted the most from growth in 30 years as the appreciating dollar caused exports to slump while imports rose following the resolution of labor disputes at West Coast ports. Instead, our forecasts imply bunds trading in a 50-75 basis point range for the remainder of the year,” Ralf Preusser, Bank of America rates strategist said in a note. This strategy involves betting bund prices will fall and Treasury prices will rise, picking up income in the meantime thanks to fatter U.S. yields as traders wait for the trade to pay off, said David O’Malley, chief executive of Penn Mutual Asset Management.

But after the weak first-quarter performance, expectations have been pushed back to September and December, while some don’t even see a move until early 2016.

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