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European junk bonds pose systemic risk in next downturn

This week, Fitch Ratings warned that record junk bond prices combined with risky corporate bond issuance is creating "increasing uncertainty" and is raising the chances of a sharp turnaround in the European high-yield, aka junk bond, credit market. Thanks to massive quantitative easing by the European Central Bank, yields on Euro junk bonds have been dropping steadily since early 2016 when the ECB began buying huge amounts of corporate debt. The most popular benchmark for European junk bonds fell below two percent for the first time ever last week. This is flat out crazy as investors are taking significant risk for just a two percent yield, less than a 5-year US Treasury Note which is considered the safest bond in the world. Fitch warned that recent market calm and the distorting impact of monetary policy "obscure the true risk-return dynamics faced by investors."

high yield or no yield

Next year will be a crucial year for European bonds as the ECB announced last month that it will cut back on its quantitative easing program from the start of next year, but it stressed that it will continue to buy sizable quantities of investment-grade corporate debt. When the ECB stops buying corporates, the junk bond market may be a huge mess as investors rush for the exit at the same time.

Unsurprisingly European corporations have been issuing record amounts of debt this year taking advantage of strong investor demand and record low yields. Formerly distressed companies in the retail sector recently raised capital via new bonds and the Italian telco Wind Tre had a record 7.3 billion Euro bond issuance that saw investor demand surpass 25 billion Euros. Wind Tre sold 5-year notes with a yield of just 2.625% and 7-year notes of just 3.125%.

While junk bonds are in high demand, it seems to have a similar feel to subprime in 2006. Back then the worst mortgages were packaged and sold as high quality with very low yields. This time it is due to central bank manipulation that is pushing junk bond yields to levels on par with the safety of US Treasuries. There is no doubt that it is a massive bubble, and it is only a question of when it will burst and hopefully the problem doesn't spread throughout all the financial system. The European economy has surprised to the upside in 2017 but this doesn't look like healthy environment and we question how long they can continue this manipulation of their corporate bond market to stimulate growth.

What happens during the next European recession? Do junk bonds trade into negative yield territory?

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About the Author: Chris Wang

Chris Wang

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