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Junk Bonds Look Like Another Bubble

Posted by Steve Markowitz on April 2, 2012

The Wall Street Journal published an article titled Junk Bonds Feed a Hungry Market that tells the tale of the growing bubble in the junk-bond market.  The first two paragraphs of the article tell the dangerous story:

U.S. companies with junk credit ratings are piling into the debt markets at a record pace, seizing on some of the lowest borrowing costs in history and strong demand from investors craving higher returns.

Companies and investors both have benefited.  Many corporate borrowers have been able to refinance debt at much lower rates, and others have been able to raise money cheaply for investments.  And so-called junk bonds, those with below-investment-grade credit ratings, have handed investors among the best returns of any fixed-income asset this year, according to Barclays PLC.  Junk bonds pay higher yields because they are considered riskier investments.”

The Journal backs its conclusion with rather ominous figures:

  • 130 U.S. junk-rated companies sold $75 billion in bonds in the first quarter of 2012, significantly up from the first quarter of 2011 and the highest quarterly figure in over 30 years.
  • The average yield on the junk bonds is just under 8%, the lowest rate in over 30 years.
  • One company, CIT, just emerge from bankruptcy a little over two years ago.  Irrespective of its poor financial performance, last month the company sold six year bonds with the yield of only 5.25%, a rate lower than this same firm paid when it sold investment-grade debt just six years ago.

The artificially low yields on junk bonds are the result of the Federal Reserve’s historically low interest rate policy.  It was a similar Fed policy that lead to distortions in the mortgage and housing markets that created the housing bubble that ultimately led to the worldwide financial market.  It is likely that the junk bond bubble will also pop with little notice as interest rates begin to rise.  This increase will cause the face value of junk bonds to drop, potentially precipitously.

While investors are aware of the possibility of problems in the junk-bond market, when these problems occur, such investors will likely claim they were duped and seek a governmental bailout; i.e. funds from taxpayers who avoided the risky behavior.  They have been taught well by recent history.

There is no such thing as a free lunch.  The longer that the Federal Reserve keeps interest rates artificially low, the greater the imbalances and bubbles will become.  As these imbalances grow, so too will the size of the ultimate correction.  The growing bubble in the junk-bond market is

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