Junk Bonds: Wall Street’s Newest Bubble?

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In an effort to nurse the long-ailing global economy, central banks around the world have maintained near-zero short-term interest rates for many years now. The Federal Reserve has even gone so far as to buy up billions of dollars worth of government and mortgage bonds and hold them on its on balance sheet, in order to hold down long term interest rates too.

While these actions are arguably justified by an epidemic of unemployment, and undergirded by decades of economic theory, they’re not without negative side effects. It’s the Federal Reserve’s intention to have low rates ripple through the the economy, but heavy central bank intervention can give investors headaches because it causes the market to behave in strange ways.

And lately, these ripples have been felt at the farthest end of the bond market spectrum — the so-called junk, or high-yield, bond market. Junk bonds are those rated ‘BB’ or lower by ratings agencies, and they are issued by companies that either have relatively risky business plans, or that already carry a large amount of debt. And because of the relative riskiness of loaning money to them, these companies typically have to pay 3% or 4% more in interest than the U.S. government does to borrow for the same amount of time.

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With interest rates being so low for so long, yield-starved investors have been increasingly willing to risk their money on junk bonds in order to get that extra yield. And as new money starts pouring into high-yield bonds, some are starting to worry that the junk bond market has reached bubble-like levels. Matt Wirz of the Wall Street Journal said as much in an article in The Wall Street Journal last week, warning that investors piling into junk bonds for the attractive yields should worry about the fact that the default rate – the rate at which companies fail to honor their debt commitments – has been creeping up lately:

“The disconnect behind falling bond yields and rising default rates reflects the mismatch between supply of and demand for junk debt as yield starved investors bail out of Treasurys and investment-grade debt and pile into the market . . . There’s a name for markets in which supply outpaces demand, pushing prices sharply above intrinsic value – asset bubbles.”

Michael Lewitt, a portfolio manager with Cumberland Advisors is also sounding the alarm. He warned clients in a recent commentary to steer clear of high yield debt, writing that investors are taking too much comfort in high-yield bond’s relative payoff vis-a-vis treasury bonds – the so-called spread – and not looking closely enough at the junk bonds’ absolute value.

Indeed, when compared to the pygmy-sized payouts of government bonds, high-yield bonds look like a great value, the spread having grown since before the financial crisis. But yields are supposed to compensate for risk. And investors who are only paying attention to the spread aren’t accounting for the fact that the junk bonds are paying 0.5% less interest than they were five years ago. And, of course, the world hasn’t gotten any less risky in the interim. He writes:

“Zero interest rate policy has created a quantum universe in which bonds and other financial instruments are, more than ever, difficult to value . . . Treasuries may not be risk-free in the way they used to be, and using them as the benchmark understates the risks associated with below investment grade bonds.”

In other words, very low interest rates on government debt don’t reflect confidence in the government, but rather the weak economy and Fed policy — so pricing any investment relative to government bonds may not be a great idea.

So is this nascent junk-bond bubble a threat to the broader economy? Probably not. A bubble bursting in the junk bond market will probably only mean losses for junk bond investors. The savings and loan crisis of the 1980s was tangentially related to junk bonds because many of the savings and loans that went under were heavy buyers of the junk bonds that fueled the take-over wars. But there were larger culprits to that crisis, namely poor bank management in an environment of volatile interest rates.

(MORE: How Dangerous Is America’s Debt?)

What all this does show is the far-reaching effects of the government’s low-interest-rate policy. Low interest rates on government bonds are rippling through the economy, and in some cases are allowing companies to borrow at unnaturally low rates. This is arguably a good thing: After all, the whole point of low interest rates is to spur lending and economic activity. But it’s also possible that such lending has gone too far — and that by inducing investors to take bigger risks for the same amount of return, we are inflating a bubble that, when it pops, is bound to make a mess.

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Donnawfh
Donnawfh

Janet answered I didnt know that a mom can profit $5559 in four weeks on the network. have you seen this (Click on menu Home)

JamesTee56
JamesTee56

The world's next debt crisis will be the looming $46 trillion corporate debt market.  As shown here, the vast majority of this market is maturing in the next 5 years and it is this debt that will be competing with sovereign debt as investors look for secure returns:

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