Bond Markets Look Quiet... Too Quiet

Bond Markets Look Quiet... Too Quiet

over 3 years ago2 mins

With economic and political uncertainties lingering, US stock volatility expectations remain high – but corporate and municipal bond investors’ relative nonchalance risks leaving them in for a rude awakening 😴

What does this mean?

The CBOE Volatility Index tracks expectations for stock price swings in the coming 30 days based on investors’ options trading – a popular way to protect against potential losses. This “fear gauge” hit its highest since the last financial crisis during March’s coronavirus-induced market mayhem – and while it’s come down somewhat since, volatility remains elevated. That’s understandable, given the current plethora of unknowns with major ramifications for investments – not least the result of forthcoming US elections.

But several big bond markets aren’t paying attention. Even as stock investors position themselves for price moves, US corporate bond “spreads” – the difference between the returns they offer and those available from super-safe government bonds – are sitting back around pre-pandemic levels. In other words, investors in company debt – albeit the highest-quality stuff – appear relatively unconcerned about the risk of defaults.

Stock volatility compared to corporate credit spreads
Implied stock (“equity”) volatility and investment-grade bond spreads have moved in sync for years

The same is true of the $4 trillion municipal bond market – debt issued by local governments in the US to fund public projects. Heightened demand for “munis” over the last couple of years has pushed up prices to their highest on record – and yields, which move inversely, to their lowest. But while the impact of anti-coronavirus measures leaves revenues dwindling and deficits swelling in even the best-run American states and cities, investors seem eerily calm… 😬

Why should I care?

With record-low returns defying economic uncertainty, the founder of hedge fund Saba Capital Management – one of the best-performing this year – reckons such bonds’ risk/reward ratio is the worst he’s ever seen. He’s betting on investors getting a nasty shock around election time as some companies’ bond prices sharply adjust to better reflect those of their stocks.

Of course, some firms – and municipalities – are in better shape than others, and shorter-term debt from larger and more resilient entities in particular may continue to offer relatively attractive returns. The US central bank has, significantly, promised to buy both types of bonds – which is likely why market waters remain so smooth 🤨

Still, two thirds of municipal bonds are owned by small-time retail investors attracted by promise of their often tax-free payouts – and with much still unknown about the state of the US (and world) economic recovery, the risk that some borrowers end up disappointing bondholders may be bigger than it seems.

Comparing corporate and municipal bonds
Corporate bonds have been less reliable in the past, but both could soon see default rates rise
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