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Is the ECB Driving European Bond Investors Into the US Bond Market?

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RANDY FREDERICK: Hello, and welcome to the Schwab Market Snapshot for June 21. I’m Randy Frederick.

Well, there’s a lot going on in the bond market and not just in the U.S. Fixed income markets around the world are seeing some highly unusual times. So, today, I’m speaking with Collin Martin, a fixed income strategist with the Schwab Center for Financial Research, to get his take on what all this means for investors. Collin, it’s great to have you back again.

COLLIN MARTIN: Thanks for having me, Randy.

RANDY: So, Collin, last week, the European Central Bank began buying corporate bonds as part of its quantitative easing program. So it seems to me that this might push the prices of those bonds up and in turn, push European investors into the United States. But what does this mean for U.S. investors in the United States?

COLLIN: It could mean that we see lower yields here. As the ECB continues to buy bonds, it’s pushing their yields lower. And European investors are looking for higher yields. So that may bring them to the U.S. looking at the higher yields we offer, like those in the investment-grade corporate bond market. Now, that has a few implications.

First, it could push our yields lower, so it could lead to less attractive entry points if we do see that. Right now, we still think investment-grade corporate bond yields are relatively attractive.

But, more importantly, if you’re holding bonds and you’re concerned about the risk of rising rates—because that would push prices lower—we think the increased demand could actually support those prices and prevent them from falling much going forward.

RANDY: Well, now, the ECB has been buying government bonds since 2015. What was it that caused them to expand those purchases to now include some corporate bonds?

COLLIN: Well, they’re running out of government bonds to buy. There are restrictions as to what they can buy, like issuer limits or issue limits—meaning they can only buy a certain amount of an individual bond. But there’s also limits about the yield they can buy. And they can’t buy bonds that have yields below the ECB’s Deposit Facility Rate. That’s a rate that the ECB sets similar to the Fed Funds Rate, and right now, that’s negative 0.4%.

Now, as a lot of investors are probably aware, a lot of European government bond yields are not just negative, but they’re even below that negative 0.4% rate. So that means that there’s a shrinking market of government bonds available for purchase by the ECB.

RANDY: Well, correct me if I’m wrong, but I think the European corporate bond market is even smaller than the European government bond market. So if they’re buying corporate bonds, won’t they eventually run out of those, too?

COLLIN: That is a possibility, but it’s too soon to know. But, yes, the European corporate bond market is smaller. It’s around 2 trillion euros. But what’s important is that around 40% of the market are bank bonds, and the ECB is prohibited from buying bonds issued by banks. So that actually makes the supply of available corporate bonds even smaller.

Now, what’s also interesting about the corporate bond buying program is that the ECB is ultimately deciding which companies and which bonds to buy. Meaning they might buy one utility company’s bonds, but not another utility company’s bonds. So it’s almost like an implicit subsidy for some of the companies whose bonds they’re buying.

And then, also, they have credit-ating parameters. The ECB is supposed to be buying bonds with investment grade ratings. But last week—in the first week of buying—the ECB bought a bond that was rated below investment grade by two rating agencies, but it had an investment-grade rating by one of the rating agencies. So they’re really on the cusp of those credit-rating parameters.

RANDY: So it sounds like they have to look at a pretty wide spectrum. Well, Collin, with all this central bank action, it seems like bond prices will just continue to go up and interest rates will just continue to come down. So from a retail investor’s perspective, does it even make sense to be in the bond market right now?

COLLIN: We think it always makes sense to own bonds. Bonds help provide income, they help provide stability for your portfolio, and they offer diversification benefits. Now, while yields across the globe are low and even negative in some places, they are positive here in the U.S.

So we think because of those relatively higher yields that U.S. fixed income investments offer, we do still think that there’s a place in your portfolio. We would still focus on core holdings—like U.S. Treasuries, investment-grade corporate bonds, and investment-grade municipals—because, again, they do offer positive and relatively higher yields.

RANDY: Well, it sounds like U.S. corporate bonds are relatively high, but they’re still historically low. So what advice do we have for investors who might be attracted to the high-yield segment of the bond market?

COLLIN: You know, we think investors should stick with their core holdings right now. And we don’t think investors are really being compensated enough in those riskier parts of the market, like high-yield bonds, emerging market debt or bank loans.

We think it makes sense to invest in them when they do have higher yields and today, they don’t necessarily have those. Yields across the board are low. And we don’t think that the yields are high enough given the risks we see ahead.

Now, the bond market is really broad, it’s really diverse, there’s a lot of different types of investments out there. So we think it’s always best to have help when you’re investing in fixed income.

So speak with a Schwab fixed income specialist. They could take a look at your portfolio, take a look at your holdings, and figure out what’s best for you to achieve your goals.

RANDY: Thanks, Collin. Fascinating stuff. If you want to read more of Collin’s bond market comments you can get that in the Fixed Income section of Schwab.com, and, of course, you can always follow me on Twitter @RandyAFrederick. We will be back again. Until next time, invest wisely. Own your tomorrow.

Important Disclosures

Please note that this content was created as of the specific date indicated and reflects the authors’ views as of that date. It will be kept solely for historical purposes, and the authors’ opinions may change, without notice, in reaction to shifting economic, business, and other conditions. The information presented does not consider your particular investment objectives or financial situation (including taxes), and does not make personalized recommendations. Supporting documentation for any claims or statistical information is available upon request.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Schwab Center for Financial Research (“SCFR”) is a division of Charles Schwab & Co., Inc.

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