The U.S. Junk Bond Bubble Is Accelerating

Deflated Balloon

Money continues to chase high yield bonds, ogling the asset classes’ 52% year to date return.

While part of this year’s rally merely recouped 2008’s lost ground, when high yield bonds fell 26%, prices aren’t looking distressed any more given the rally. New issuance is booming, which is basically a sign that issuers see a good chance to pay low yields to over-eager investors.

Thus with the rally, ‘Junk bond’ investors are accepting less and less yield in the face of three serious risks which are pretty serious: Risk of a weakening dollar, risk of rising interest rates, and of course, risk of default.

As the Fed draws liquidity out of the system and ends treasury market support, high yield bonds could be one of first casualties if interest rates thus rise.

Business Week: Another red flag, at least among fixed-income cognoscenti, is that for the first time in five years the default rate for junk bonds now exceeds their spread to Treasuries. All of which suggests investors are ignoring historically high levels of default risk, increasing the chances that the market rally will overheat or even collapse. “We expected high-yield bond yields to come down, but not this fast,” Leuthold analysts wrote in an October dispatch, in which the firm urged clients to start taking profits. “We expected a three- to four-year play, not nine months.”

But good luck trying to tell a white-hot junk-bond market to chill. According to Dealogic, the current quarter’s new junk issuance is tracking at just a bit less than $42 billion—nearly eight times the sales of a year ago.

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