The market's $1 trillion bubble is unprecedented

Junk bonds are living up to their name right now.

As we’ve noted in the past, the lowest-rated junk bonds may have inflated a $1 trillion bubble at the bottom of the debt market. The thing is, it never should have gotten that way.

Kathy Jones, chief fixed income strategist at Charles Schwab, said that in the past, the level of low-rated debt issuance (CCC-rated and below) would have never happened.

“Back when I was in school, you wouldn’t even talk about those kinds of things because you couldn’t even issue CCC bonds,” Jones told Business Insider.

The shift, according to Jones, is that in the post-financial crisis era the low yield of many fixed income assets lead to the search for yield. This demand for products in which income investors could make a good return created a situation in which these deep-junk issuers could find a large market.

“This reach for yield really opened the window for these kinds of products,” said Jones.

Jones didn’t discredit the possibility of a bubble, but doubted that the ramifications would spread.

“The market does a pretty good job of discounting that risk,” said Jones. “There may have been a time where that would have been a issue but it seems that the market has appropriately recognised the risk there.”

After the spike in all bond spreads in the beginning of 2016, higher-grade spreads such as for BB grade have tightened and are approaching levels not dissimilar to other points during the recovery.

Spreads on CCC and below on the other hand are still wider than at any point since the recession. So it would appear that even after the recovery in spreads, there is some cautiousness around these deep-level bonds.

Jones also surmised that this new “window” that allowed much of the issuance to happen had “snapped shut” during the shaky first quarter of 2016, and is only now starting to creak back open, but not as much for deep-junk.

There are two ways to read this. On the bearish side, this weakness in deep-junk bonds could be a harbinger of tough times for all of the debt market. On the more bullish side, as Jones alluded to, it could simply show that market is protecting itself and finally properly acknowledging the risk associated with these bonds.

According to Jones, the problem with these kinds of bonds is that the risk/reward calculation is asymmetric. The possibility of default is usually not worth the higher yield.

For that reason, Jones also had a simple suggestion has for regular investors.

“You should never buy these bonds,” Jones said. “They may be something for alternative hedge funds and those sorts of investors, but individual investors should just stay away.”

This makes sense, as large alternative investors such as Blackstone and Lazard have noted that distressed debt (debt from companies close to or in bankruptcy) is about to become very active.

So the once unthinkable level of deep junk bond issuance became a reality, and hopefully investors have protected themselves.

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