Goldman Bond Follow-up Re European Crisis

The Goldman Sachs commentary on volatility in the junk bond market, quoted in the post below, suggests an added risk factor should investors move substantial capital out of this asset class.

The European debt crisis has been generating cycles of bad news/good news as problems crop up, policymakers take measures that seem to work and then problems crop up again.  Investors have reacted to this in risk-off/risk-on cycles, moving away from riskier assets such as junk bonds when there is bad news, moving back in when a policy measure appears to contain the latest manifestation of the crisis.

In the meantime, buying and selling high-yield bonds has became harder and price variations greater. This appears to be a consequence of coming new regulations—dealers reduced their high-yield holdings and bank prop desks are no longer active.

The danger is that a substantial outflow from high-yield could result in magnified price movements in the thin market. That would adversely affect balance sheets, pulling down the value of high-yield holdings, possibly causing a downward spiral as investors try to reduce their exposure, with new rounds of selling in the shallow market further bringing down prices.

How likely is that to happen? Investors want the higher yield they can get on junk bonds, since interest rates are so low. And in time the market is expected to build up liquidity, helped by new trading platforms.

But in the short-term, if there is a major escalation in the crisis, a big risk-off move could result in a downward spiral.

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