The Next Financial Crisis: Junk Bonds

By Pam Martens: May 31, 2013

Ignore this past week’s trading in the junk bond market at your own peril.

On May 7 and May 8 of this year, junk bonds fell to record low yields of 4.97 and 4.96 percent, respectively, according to the Barclays U.S. Corporate High Yield Index. (Wall Street prefers the misleading title of “High Yield” to peddle its junk bond wares.) Back in 2008, junk bond yields were trading as high as 19 percent. (Junk bonds are those rated below Baa3 by Moody’s and below BBB- by Standard & Poor’s.)

In the last two weeks, junk bond prices have been selling off as everyone from small investors, pension funds, insurance companies and mutual fund portfolio managers reassess the amount of bond support that will be coming from the Federal Reserve in the future. While prices of Treasury bonds and investment grade corporate bonds have also sold off, there has been a notable deterioration in the junk bond area, with a particularly sharp sell off earlier this week.

According to Lipper, there was a massive net outflow of $880 million for the 7-day period ending May 29 from mutual funds and ETFs (exchange-traded funds) invested in junk bonds.

Bond investors were glued to the testimony of Federal Reserve Chairman, Ben Bernanke, on May 22 before the Joint Economic Committee of Congress. While Bernanke downplayed a rebound in the jobs picture, he also raised questions as to just when the Federal Reserve would stop supporting the overall bond market with its $85 billion monthly purchases. Currently, the Federal Open Market Committee (FOMC) of the Fed is keeping yields low by purchasing $45 billion per month in long-term U.S. Treasury securities and $40 billion per month in mortgage-backed securities (MBS). Since junk bonds trade as a yield spread to Treasuries, any back up in Treasury yields will impact a decline in prices of junk bonds and a rise in yield. (In Wall Street lingo, bond prices move inversely to yield.)

This is what Bernanke had to say on the jobs front and the bond-buying program:

“…the job market remains weak overall: The unemployment rate is still well above its longer-run normal level, rates of long-term unemployment are historically high, and the labor force participation rate has continued to move down. Moreover, nearly 8 million people are working part time even though they would prefer full-time work. High rates of unemployment and underemployment are extraordinarily costly: Not only do they impose hardships on the affected individuals and their families, they also damage the productive potential of the economy as a whole by eroding workers’ skills and–particularly relevant during this commencement season–by preventing many young people from gaining workplace skills and experience in the first place. The loss of output and earnings associated with high unemployment also reduces government revenues and increases spending on income-support programs, thereby leading to larger budget deficits and higher levels of public debt than would otherwise occur…”

Later in his talk:

“…the Committee is aware that a long period of low interest rates has costs and risks. For example, even as low interest rates have helped create jobs and supported the prices of homes and other assets, savers who rely on interest income from savings accounts or government bonds are receiving very low returns. Another cost, one that we take very seriously, is the possibility that very low interest rates, if maintained too long, could undermine financial stability. For example, investors or portfolio managers dissatisfied with low returns may ‘reach for yield’ by taking on more credit risk, duration risk, or leverage. The Federal Reserve is working to address financial stability concerns through increased monitoring, a more systemic approach to supervising financial firms, and the ongoing implementation of reforms to make the financial system more resilient.”

The “reach for yield,” as Bernanke notes, is likely to be the next landmine going off on Wall Street. Just this year alone, according to Bloomberg, Wall Street has pumped out $188.8 billion in junk bond offerings.

According to the U.S. Census Bureau, there are almost 42 million people in the U.S. aged 65 or older – many of whom are retired and living on fixed income. As yields on traditional forms of investments plunged (Certificates of Deposit, savings accounts, Treasury notes and bills) many retail investors have been seduced into “High Yield”  bond funds or related products. Many are not aware that they are actually invested in junk bonds.

The Financial Industry Regulatory Authority (FINRA), Wall Street’s self-regulatory body, is aware of the dangers to unsophisticated investors in high yield bonds and has been ramping up the alarm bells over the past few years on its web site. Unfortunately for many seniors, they’ve only had a choice between low yield or high risk since Wall Street crashed the economy in 2008.

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