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31. October 2014 12:05
by Allan

As the mask slips for European High Yield bonds, post QE, the masquerade is over

31. October 2014 12:05 by Allan | 0 Comments

With the topic of high yield bonds being in the news of late, it is becoming more challenging than ever to detect the signal from the noise. What fate lies in store for this asset class is anyone's guess, and to be honest most people appear to be guessing. However, when the likes of the legendary investor Carl Icahn throws his hat in the ring, as he did recently by declaring high yield was in a bubble, maybe it's time to look at the data again.

Source: Twenty20 Investment, Markit

By their very nature high yield bond indices provide an excellent voting mechanism for the market to express its preference for holding risky assets. For that reason alone, this topic should be filed under behavioural finance rather than technical analysis, but as we all know habits die hard.

Timing one's exit in any asset class is never easy, for one renowned for its high level of jump risk; it becomes the problem best avoided. By looking at the histogram of monthly returns over the full index history, one can at least put a number against the worst case loss.

The tail event dating back to 2008 saw a drop of 22% during a single month, not for the feint hearted. More typically the gap risk on that timescale is in the 6% range. Not a figure that would alarm an investor who specialised is UK supermarket stocks, but drawdowns of this size are still best avoided.

Source: Twenty20 Investment, Markit

If one instead looks at the rolling one year standard deviations of monthly returns, the alarm bells start to ring for many investors. After five years of a historically low interest rate regime, the spread over European Government Bonds isn’t the no brainer ‘indicator’ that it once was. In the absence of a reliable guide as to what the new norm for spreads should be, how can one avoid complacency? Looking at the rolling one year volatility of Euro High Yield Bond index returns should do the trick and very quickly set the alarm bells start ringing. With these risk levels having come off their all-time low of just below 1%, one can see these European high yield bonds have been masquerading as short dated government bonds, which currently are showing risk levels in the 1.5% to 2% range.

With the announcement this week that QE has finally come to an end, albeit with Japan having decided to take its turn holding the stimulus baton, it is only a matter of time before the spread between the 1yr historical volatility of short dated government and high yield bonds reverses sign,
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