Since the beginning of this year, almost every sector in the bond market has strengthened, including Treasuries, high yields, munis and preferreds.
"That doesn't normally happen—long Treasuries producing double-digit returns along with high yield at the same time," said Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research. "At some point the market will need to recalibrate."
Could Tuesday's bond market selloff, in tandem with the sharp decline in stocks, indicate the start of that recalibration?
Jones thinks so. "The prospect of less monetary stimulus going forward means markets not only have to reprice interest rates risk but also credit risk. It can probably extend further. Given that the term premium has been negative, there is room for bond yields to rise and credit spreads to widen."
The yield on the 10-year Treasury note, which moves in the opposite direction of its price, jumped to 1.73% Tuesday, its highest level in three months as a Bank of America survey showed investors boosting cash levels to their highest level in almost 15 years. The 10-year finished the session at 1.72%.
Jones and her colleague, Collin Martin, director of fixed income at Schwab's Center for Financial Research, are cautioning investors against reaching for yield, which has led many to pour money into emerging market debt and high yield debt in order to collect more income.
According to Bank of America Merrill Lynch's latest weekly data, inflows into emerging market debt over the past 10 weeks were the biggest ever. High yield bond funds had positive inflows for the past 9 out of 10 weeks, and investment grade bonds funds saw positive inflows for the past 26 out of 27 weeks. In comparison, government bonds had their largest outflows in the past six months.
The bank's survey of fund managers showed a net 54% of respondents said bonds and stocks are both overvalued, which was the highest level since May 2000.
Schwab analysts are not yet underweight emerging market or high yield bonds because of their relatively high coupons, but they are cautious because spreads to Treasuries are tight. The average spread of the Barclays Aggregate High Yield spreads to Treasuries is 4.9% currently, compared to 5.5% historical average, said Martin at a morning meeting with reporters. These tight spreads suggest investors aren't being paid to take the additional risk.
(Related: Gundlach: Time to Be 'Defensive' With Bonds)
