Is the Market's Risk Profile Changing?

07/25/2014 12:01 am EST

Focus: GLOBAL

Jim Jubak

Founder and Editor, JubakPicks.com

The hot junk bond market appears to be cooling says MoneyShow's Jim Jubak, who looks overseas to assess if this signals a change in investors' appetite for risk.

The characteristic of the stock market, bond market too, in this age of the global central banks and their cash flow is this fluctuation between risk on and risk off. Risk on is when you're willing to buy things like the shares of Brazilian chicken producers or Kenyan bonds. That's when you think buying risk makes sense. Risk off is when you go oh my God, the world's falling apart and all you want to do is hold yen. You don't care whether the Japanese economy's ever going to grow again because it's really, really liquid and maybe you'll buy gold and soybeans and stuff like that. For the week ahead, we need to figure out whether what we're seeing in July so far is a swing from risk on to risk off or whether we're seeing something that's being really driven just by big new stories like Gaza, like the shooting down of the plane in Ukraine, all that stuff. Okay, here's what has happened. High yield, otherwise known as junk bonds, have been on a tear that people have basically said yeah, yeah, we know they're risky but (a) we need the yield and (b) the economy's picking up so they're not going to be that risky so for the last 10 months, this has been an asset to own. In fact, over the last 10 months, junk bonds have returned about 10.4%. That's total return so that's price plus interest, okay. Not bad for a bond that's only paying 5% to 6% so a lot of this is actually capital appreciation.

Okay, that was true through the end of June. What's happened since then is that you've seen money come out of junk bond funds so that, for example, the High Yield Fund run by Bill Gross' PIMCO has seen about $600 million to $700 million worth of redemptions cash flow out. Junk bonds themselves haven't fallen a lot but they're down about six-tenths of a percent for July and that's a big change in momentum. The question now is are people saying oh, I'm a little frightened by Gaza, I'm a little frightened by the possibility of war on the Russian Ukrainian border so I'm going to pull back. I'm going to go a little toward risk off because I don't want to be as exposed so all you're really seeing is people reacting to news or you're seeing a bigger switch in the trend because the presence of these assets have climbed so high, you're talking about a real shrinkage of the spread between junk bonds and treasuries. You're not getting a whole lot of extra yield for your risk so the other possibility is that people have said oh, these assets are fully priced so therefore, I'm going to sell. One place I'm looking to try to figure out whether we're seeing a big trend or something that resembles a reaction to news is looking at emerging market debt.

It's been a huge year for sales of emerging market debt as people have said oh, okay, so I'm willing to buy bonds of Ecuador or Kenya because the world seems a relatively safe place in terms of the central bank support for all of this. The assets have been climbing. You've had countries that haven't been able to access the market for a while like Ecuador and Kenya to be able to sell bonds to the international market. So far, you're not seeing a big pullback but what you're seeing is sort of rhetorically, people saying hey, this may be getting out of hand. The memory here is to go back to May 2013 when we had what is now known as the taper tantrum when just simply an announcement by Fed Chairman Ben Bernanke that he was thinking of a taper caused a big selloff in risk-on assets and you had about an 8% drop in emerging market stocks and about a 12% drop in emerging market bonds. If we go back to that and that's the fear, this would be a pretty big hit so that's what I'm looking at right now, trying to decide news or trend switch. I think we'll know maybe a little further into July or early August. This is Jim Jubak for the moneyshow.com video network.

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