Bonds: Geopolitical Risk Rears Its Head

July 18, 2014 2:30 PM
By Zane Brown

Developments in Ukraine and the Middle East sparked volatility in fixed-income markets on July 17. Here’s a look at the implications for investors. 

Geopolitical risk, which largely has been brushed aside by the fixed-income market in 2014, seized the spotlight on July 17. News of a downed Malaysian airliner in Ukraine, and military incursion by Israel into Gaza, fueled a “flight to quality” trade that pushed U.S. 10-year Treasury prices higher and yields lower. The yield on the 10-year note touched 2.44% on the session, matching the low for 2014 (all data on bond yields and spreads in this post are from Bloomberg). High-grade corporate bonds also benefited, as investors redirected assets toward higher credit-quality securities. 

The flight to quality was reflected also in redemptions of high-yield bond funds, especially exchange-traded funds (ETFs), causing yield spreads versus Treasuries to widen. After withdrawals of $1.68 billion in high-yield funds for the week ended July 18 (according to Lipper data), investors appeared to want little part of riskier assets, as high-yield ETFs lost $434 million and actively managed high-yield funds experienced withdrawals of $175 million. Yield spreads widened accordingly, by 10 basis points (bps), on July 17, and by more than 30 bps for the week. 

Markets seemed to have calmed down slightly on July 18, allowing the yield on the 10-year Treasury to correct slightly, to 2.50%. It may take slightly longer for high-yield markets to adjust, but the widespread investor demand for yield seems likely to regenerate interest in high-yield securities, which would help prices recover and would narrow spreads over the coming weeks. This opportunity in U.S. high yield also could gain some support from the impact of this latest bout of geopolitical turmoil on economies in the eurozone. Fear of slower growth in Europe may be reflected in greater unwillingness to invest in the eurozone’s peripheral economies, promoting investment flows into U.S. high-yield securities that may offer greater yield and the chance for better total return. 

To be sure, the developments in Ukraine and Gaza serve as reminders of a perilous world. But investors would do well to remember that the market volatility generated by such events may otherwise provide opportunity.

Zane Brown is a Lord Abbett Partner and Fixed Income Strategist.

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