How Credit and Bond Market Risks Affect 2016’s Investment Outlook
2016 key risks
While 2016 may have many relative value and arbitrage opportunities to offer amid the heightened global uncertainty, there are certain key risks that investors should bear in mind before taking a leap.
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Bond market tumult and the flattening yield curve
As interest rates increase, the US economy (SPY) (IWM) should see bond prices decline. Bond (BND) prices and interest rates are inversely related. Plus, there is the greater concern over the flattening Treasury yield curve, suggesting we may start showing signs of inversion. Short-term Treasury (SHY) yields are rising at a faster rate than longer-term Treasury (TLT) yields. Inversion of the yield curve has historically predicted a recession. Read Fed Hikes the Interest Rate: Will It Invert the Yield Curve? for more information.
Moreover, the high yield (or junk bond) market is dominated to a large extent by energy sector issuers. Most MLPs belonging to the energy sector (AMLP) issue a lot of high yield debt. The rise in borrowing costs in the US is definitely bad news for upstream oil companies such as Chesapeake (CHK). The oil price slump has put many of these energy firms in a critical financial situation. Increased borrowing costs would cause bonds issued by these firms to hit the ground. Moreover, the markets may also expect the CDS (credit default swap) rates on these bonds to soar as the cost of insurance against them increases (with declining creditability).
Credit crisis in emerging markets
With the expected fund flow diversion to the US and the strengthening dollar against emerging market (EEM) (VWO) currencies, we may see emerging market debt come under pressure. As the dollar strengthens against these currencies, US dollar-denominated debt from these nations will become more and more expensive and lead to repayment issues.
In the next article, we’ll look at the risks residing on the equity, earnings, and geopolitical fronts as we step into 2016.