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Fading confidence in “junk” bonds?

In the wake of recent adverse news about an investment known as Third Avenue Management’s Focused Credit Fund, “lapsed blogger” David Dayen expresses concern in this post at Naked Capitalism that high-yield corporate bonds could be the next big US asset class to be the epicenter of a financial crisis. This market, which expanded briskly for many years, experienced its most notorious crash in the late 1980s. Years of stability in this risky market perhaps account for a rise in market complacency and a weakening of credit quality. Financial crises tend to be presaged by relatively minor, seemingly isolated credit events that occur however during intervals marked by upward trends in fragility.

Yields such as the ones in the figure above move in the opposite direction as prices. In other words, weakening demand for a type of bond has the effect of lowering its price or increasing the yield insisted upon by the market. Our figure shows an interesting contrast. On the one hand, the path of the red line shows that investors have been losing confidence in high-yield, long-term debt from large companies, demanding more compensation for bearing the risks associated with this form of debt, including default risk. (As seen in the figure, the last big upward move in these yields occurred in connection with the most recent US financial crisis, which began in about 2007.) On the other hand, the path followed by the blue line shows that yields on the long-term liabilities of the US government have been far more stable, reflecting the fact that markets are aware these liabilities are backed by the “full faith and credit” of a sovereign issuer (a government with its own unpegged currency). Hence, the figure suggests that rises in yields on “junk” are not mostly the product of forces generated by the impending adjustment in the shorter-term federal funds rate, which presumably affect both series. (U.S. Recessions are shown in the figure as shaded areas. The data are monthly.)


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