You Call This a Bond Rout? Wait Until the Real Selling Starts

All Eyes Are on a Global Bond Selloff

If you think the latest hiccup in world bond markets looks bad, wait until investors actually start selling their holdings.

Yes, German and U.S. bond yields have soared to their highest levels this year. And, yes, more than $626 billion of value has simply evaporated from an index of global sovereign bonds since the end of March.

But all bond owners aren’t racing to the exits just yet. Investors have actually poured almost $1 billion into fixed-income exchange-traded funds over the past week, just one proxy showing sustained demand for debt, according to data compiled by Bloomberg. While trading volumes are somewhat higher than average in Treasuries this year, they’re pretty typical for corporate bonds and not what you’d expect in the case of a wholesale exodus.

“Volume has been significant but not frenetic given the move in yields,” wrote Jim Vogel, an interest-rate strategist at FTN Financial, in a note Thursday. “It is still not clear to most market participants what is driving the intense sale” of European bonds.

There are some commonly cited reasons for the latest rout, which caused Bank of America Merrill Lynch’s $25.4 trillion World Sovereign Bond Index to lose 1.2 percent in the first three days of June.

Cold Comfort

Inflation is picking up in Europe more than analysts forecast, which European Central Bank President Mario Draghi has attributed to the region’s unprecedented stimulus program. Rather than accelerating easy-money policies, Draghi simply told traders to get used to volatility, which wasn’t the comforting message they were looking for.

Meanwhile, economic data in the U.S. is looking good enough for speculation to mount that the Federal Reserve will, in fact, raise interest rates this year for the first time since 2006.

There’s a concern that if yields rise too quickly, causing bond-fund investors to see big losses on their monthly statements, these buyers will yank their cash all at once, causing a spiraling effect for the debt.

Bank of America Corp.’s Hans Mikkelsen warns that losses will be particularly steep in investment-grade debt funds if Treasury yields rise too rapidly in upcoming weeks.

Fragility Prone

Here’s why: investors in bond funds are more inclined to pull money when returns go negative than stock-fund buyers, according to an April paper by professors Itay Goldstein at University of Pennsylvania’s Wharton School of Business, Hao Jiang at Michigan State University and David Ng at Cornell University.

“Our empirical results suggest that corporate bond funds are prone to fragility,” they wrote. “The illiquidity of their assets seems to create strategic complementarities that amplify the response of investors to bad performance or other bad news.”

Tempering fears of bond-market Armageddon are economic data that aren’t all that fantastic just yet. Consumer-price growth has been so unimpressive that the International Monetary Fund on Thursday advised the Fed to wait until next year to start raising rates. While too much inflation can be bad for consumers who face higher prices for goods and services, a moderate amount can be healthy, resulting in faster wage and economic growth.

Buying Opportunity

Most selloffs in recent years have proved to be buying opportunities, with notes quickly rebounding after they fall. This time looks to be similar, if price action on Thursday is any indication. Yields on benchmark U.S. Treasury 10-year notes dropped to four basis points, or 0.04 percentage point, to 2.32 percent as of 1:18 p.m. in New York on Wednesday, falling from the highest level since October.

Yields on similarly-dated German bonds fell to 0.84 percent Thursday following their worst two-day performance since the euro-area’s creation.

Without a significant change in the fundamental backdrop of central-bank stimulus and relatively slow growth worldwide, big investors are showing they’re not quite ready to part ways with their bonds. When they are, that’s when the drama will really ensue.

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