Market Insider

Bond yields scream higher, give eerie glimpse of future

Santelli: Yields surge higher
Santelli: Yields surge higher

The wild breakout in German yields is rocking global debt markets, and giving investors an early glimpse of the uneasy future for bonds in a world of higher interest rates.

The shakeout also carries a message for corporate bond investors, who have snapped up a record level of new issuance this year, and are now seeing negative total returns in the secondary market for the first time this year.

As German bund yields zip higher, they are pulling European sovereigns and U.S. Treasury yields higher with them. The 10-year Treasury yield jumped Wednesday to 2.38 percent, the highest since November. The 10-year bund, at 0.71 percent just Tuesday, shot higher and neared 0.9 percent.

Read MoreECB's Draghi rules out early taper

Santelli Exchange: Gundlach, Bianco talk rates
Santelli Exchange: Gundlach, Bianco talk rates

The U.S. Treasury market has been tethered to Europe, as the European Central Bank earlier this year committed to an easy money policy, the opposite direction U.S. central bankers are expected to take. In contrast, U.S. Treasurys were higher yielding and relatively more attractive, but now as Europe has sold off, the U.S. is going with it.

Traders say the rapid move in the U.S. market shows a detachment from fundamentals, and the move in Treasurys itself could take on a life of its own.

European yields are rising on an improving economy but also because ECB President Mario Draghi in comments Wednesday made no commitment to tame European rates.

Read MoreGundlach: Fed won't raise rates this year

"He didn't' give any sense that if yields keep rising, they might push back," said John Briggs, head of strategy at RBS. "He basically said volatility is part of this process."

Briggs said if the U.S.10-year breaks through 2.40 percent, it's next level may well be 2.60 percent.

Bank of America Merrill Lynch strategists said, in a note, the bund yield could be getting close to a top on a technical basis, as are U.S. 10-year note yields. They said the U.S. 10-year yield could move deeper into the 2.366/2.429 percent range before falling back to a range between 1.957 and 2.161 percent.

U.S. yields are also supported by signs of improvement in the economy and the prospect of pending Fed rate hikes, and as they move higher, prices fall and yields rise in the corporate bond market.

"We're having a rout in the bond market now, but if you go back to January it was the best month in the history of the bond markets" Bianco Research's Jim Bianco said on CNBC's "Squawk on the Street." "In the same year, we're having this rout, you also had the best month ever. That's the history of the bond market. It either booms or busts."

Read More10-year yield hits highest since 2014

As Treasurys sell off, the corporate bond market, a relative sea of tranquility, is sending its own signals. One market player said the total return on high grade corporates was up a little over 1 percent at the start of May, but the total return on the same bonds year-to-date due to the dramatic price drop was fractionally negative by June 1. Total return is a measure used in the bond market to reflect not just changes in price but also income—or the rate of return on the investment including the coupon.

"It's having a heavy influence on returns in the corporate bond market, and total return for investment grade corporates is now negative," said Briggs. He said the high yield market has not been as impacted. "You get a bigger coupon and more cushion."

Also exacerbating the move in investment grade has been the gusher of new corporate credits that have rushed to market, as interest rates look set to rise.

Doubeline Capital CIO Jeff Gundlach, in an interview on "Squawk on the Street," said ultimately bond funds and ETFs that hold corporates are at risk.

"I think they're vulnerable particularly if interest rates rise, which is a nonconsensus point of view," said Gundlach. "Most people think that corporate bonds particularly junk bonds, are somehow going to save you if interest rates are rising. I think that's wrong.

"I think people were hungry for yields, starvation for yields, and buying corporate bonds and junk bonds was one way to try to accomplish something in terms of yield land," he said. "But if yields are rising then starvation for yield is actually abating. A bigger topic…is the corporate bond market, the junk bond market, in particular, has never experienced secularly rising interest rates."

Gundlach also commented on total negative return and said investors could be blindsided. "I think investors, if what's going on now continues, they're going to be a little unpleasantly surprised when they open up their statements … for the end of June, if this yield rise continues, we're going to be looking at negative returns for corporate bonds particularly long-duration corporate bonds with the steepening of the yield curve," he said.

Gundlach said he expects the German bund market to continue to cause volatility and U.S. rates should continue to move higher, but not significantly.

While bonds yields ripped higher Wednesday, stocks rallied on the prospect of a resolution in Greece's debt talks.

"The bond market volatility has been much higher than the stock market volatility this year," said Cliff Noreen, president of Babson Capital. "It's partly due to less liquidity in the bond market globally. It's causing higher volatility."

The lack of liquidity has been blamed for rapid spikes in usually staid sovereigns. As for corporates, spreads have stayed fairly tight. "They have underlying fundamentals that are very strong, but that's because of corporate profitability being at record highs," said Noreen.

George Goncalves, head of rate strategy at Nomura, said if the Fed were to hike rates, the focus would move from longer term rates to the short end of the curve. "That would maybe take some pressure off the euro currency and that might stabilize things."

"This move has been primarily a long term rate move. If it gets unhinged then that can cause a problem for the Fed because they can't hike as much," he said.

Goncalves said the corporate bond market could become a concern. "If this were to infect the corporate bond market, at that point, the Fed would take notice and worry. The corporate buybacks are linked to the corporate issuance. And M and A activity is on the back of the corporate bond market. If the rates start to infect the corporate bond market, then you have broader market implications."

Gundlach said high yield corporates could face as yet unforeseen problems in the future.

"If interest rates rise this kind of systematically for the next three, four, five years there is going to be a very different context for junk bonds then anybody's has experienced. There will be a wall of maturities that come in 2018 and 2019 and if interest rates are rising these companies will have to roll over the debt at higher interest rates, that's something that has never happened in the history of the junk bond market," he said.

Gundlach said this could conceivably have implications for future corporate default rates, which average 4 percent.