An early warning system
Bond markets have proven their worth in the past when it comes to signalling trouble in particular. Indeed, some joke that bond investors are the sort you don’t invite to dinner as they tend to make money from bad times. Why? Well, when an economy struggles, central banks tend to cut interest rates and that in turn usually boosts the prices of fixed income securities, which most bonds are. Some of the smartest brains in finance work in fixed income and they are paid handsomely to read market conditions correctly. So how can you tell when they might be getting jittery?
4 key signals
Here we will just look briefly at four indicators of bond market stress. None should be trusted completely in isolation but together they can be powerful.
A yield is the expected annual return from a bond as a percentage of its price. As a rule of thumb, the riskier the bond, the higher the yield and the longer-dated the bond, the higher the yield too. So a long-dated, risky bond will carry a high relative yield.
When yields start rising across the board, it can therefore be a sign of bond market stress because it suggests investors are demanding higher returns for holding any bond.
The yield curve
I cover this in more detail elsewhere, so in a nutshell, the flatter the yield curve, the greater the chances that bad economic news may be on the horizon. Why? Because if investors are piling into longer-dated bonds, they are in effect sacrificing their normal time preference for the chance to lock in a decent long-term yield. You might do this if you expect interest rates to fall because a Central Bank wants to stimulate a flagging economy. This signal isn’t fool-proof but it is worth monitoring.
Agencies such as Moody’s and S&P are paid to rate government and corporate debt. If they are confident about the financial stability of issuers they will tend to issue strong ratings. However when they get nervous about issuers, whether governments or companies, ratings can start to slip. Sudden changes are of particular interest.
Once again, in isolation credit ratings are not to always be trusted and may not even be available on all types of debt, but they are nonetheless worth watching.
As economic conditions deteriorate, investors will demand ever more, in the form of a yield, from riskier bonds (such as those issued by companies) than safer ones (such as those issued by governments). This is reflected in the credit spread. A widening spread can be a sign of impending trouble.