“The Federal Reserve has kept short-term interest rates near zero for seven years and bought trillions in bonds to push all bond rates down—in a deliberate effort to encourage investors to seek out higher rates and accept the risk that goes with them. Investors obliged…

…According to Dealogic, U.S. junk-bond issuance hit a record $361 billion in 2013, after $355 billion in 2012. Those totals were more than double the volumes in the years before the financial crisis. Investors also began to see junk bonds as less risky, judging by the spreads. This is the interest paid on the bonds over and above what investors can receive holding U.S. Treasury bonds. According to Bank of America Merrill Lynch, which maintains a popular measure of this spread, the long-run average since 1990 is 558 basis points. But with the Fed encouraging risk-taking, it fell below 340 in June of 2014. Investors weren’t demanding much extra compensation for the extra risk…..on Monday the high-yield spread over Treasurys had climbed to 710 basis points—more than twice the level of late June 2014, and investors are getting whacked. The risk of any illiquid market is that a mild correction can turn into a larger panic if sellers can’t find buyers. One place to watch in particular is the energy industry, where borrower fundamentals do look bad thanks to the Fed-inspired commodity-price boom and bust. The post-crisis meddling in markets was done in the name of reducing risk, but it has created new risks of its own.”, The Wall Street Journal Editorial Board, December 15, 2015

Opinion

The New Bond Market

Encourage record sales of bonds, while telling banks not to buy them.

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PHOTO: GETTY IMAGES/ISTOCKPHOTO

The good news about the junk-bond selloff shaking financial markets is that taxpayer-backed banks generally aren’t absorbing the losses. The bad news is that with America’s new financial architecture it doesn’t take much to trigger a steep decline.

Junk or high-yield bonds are loans to companies of questionable credit quality. And a popular exchange traded-fund that tracks the junk-bond market is down nearly 8% since early November and about 12% on the year. The Federal Reserve has kept short-term interest rates near zero for seven years and bought trillions in bonds to push all bond rates down—in a deliberate effort to encourage investors to seek out higher rates and accept the risk that goes with them. Investors obliged.

According to Dealogic, U.S. junk-bond issuance hit a record $361 billion in 2013, after $355 billion in 2012. Those totals were more than double the volumes in the years before the financial crisis. Investors also began to see junk bonds as less risky, judging by the spreads. This is the interest paid on the bonds over and above what investors can receive holding U.S. Treasury bonds.

According to Bank of America Merrill Lynch, which maintains a popular measure of this spread, the long-run average since 1990 is 558 basis points. But with the Fed encouraging risk-taking, it fell below 340 in June of 2014. Investors weren’t demanding much extra compensation for the extra risk.

Meanwhile, the Fed and other regulators were also limiting the ability of large banks to buy these instruments. So while the junk-bond supply was expanding, the demand among big banks has been constrained by regulations in the wake of the 2010 Dodd-Frank law.

The result is that these bonds are now more likely to be held by corporate treasuries and mutual funds—institutions that carry less leverage and aren’t backed by taxpayers. This is good for bank stability in a systemic crisis (assuming the assets regulators tell banks to hold aren’t even worse). But many on Wall Street have been wondering what will happen when a market downturn occurs and banks are largely not available as distressed-bond buyers when investors wish to sell.

Well, here we are. It’s tempting to call this a stress test of the new markets that Washington has created, but the underlying economic conditions aren’t all that stressful—yet. Through November the default rate on junk bonds was 2.6%, not all that high considering defaults spiked to nearly 12% after the financial crisis. Defaults exceeded 12% after a recession in the early 1990s and were beyond 14% in the early 2000s.

Yet on Monday the high-yield spread over Treasurys had climbed to 710 basis points—more than twice the level of late June 2014, and investors are getting whacked. The risk of any illiquid market is that a mild correction can turn into a larger panic if sellers can’t find buyers. One place to watch in particular is the energy industry, where borrower fundamentals do look bad thanks to the Fed-inspired commodity-price boom and bust.

The post-crisis meddling in markets was done in the name of reducing risk, but it has created new risks of its own.

Posted on December 16, 2015, in Postings. Bookmark the permalink. Leave a comment.

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