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Junk bonds: ongoing disaster

investment junk spread

Gretchen Morgenson argues in the New York Times that the below-investment-grade bond market in the U.S. may be headed for more losses. On Sunday, Dealbook columnist Landon Thomas discusses emerging-market fears among investors . Earlier  in the month, the New York Times‘s end-of-year mutual fund report weighed the pros and cons of junk bonds as an investment in light of recent bond-market turmoil, after a bad year for investors in these risky securities. Finally, reporting this weekend on a related development, the Times finds an increased likelihood of the occurrence of the largest default so far by a Puerto Rican municipal-bond issuer in its debt crisis. The figure at the top of this post shows sharply rising yields on an index of bonds with a very low rating in contrast to more stable yields on a related investment-grade index. Bond yields and prices move in opposite directions. The widening spread between the two yield series indicates that investors are demanding greater compensation for holding securities issued by companies regarded as less creditworthy.

Some points made recently by people who are optimistic about the U.S. macroeconomic impact of the decline in the below-investment-grade market:

*The problems at this point are largely confined to certain industries, which account for a large percentage of distressed securities within the “junk” category

*The total “junk” market not nearly as large and as important to sectors with high spending propensities. Compare this episode to the housing bubble. The size of the “junk” market is probably between $1 trillion and $2 trillion, in contrast to the more-than $10 trillion in housing wealth. Moreover, housing wealth is far more widely dispersed among households than financial wealth in the U.S.

*The biggest losses are confined to the lower tiers of “junk,” such as those involved in the collapse of Third Avenue Management, which I discussed in this December post.

*The recent bond-market drop may be mostly an oil bust with implications for investors in securities whose value depends on oil revenues, rather than a financial bust per se. Difficulties repaying and borrowing may simply reflect a lack of demand for petroleum due to weak demand in China and elsewhere where growth has slowed.

*Many analysts tell a story about adverse “long-run implications” of the Fed’s response to the Great Recession and financial crisis—a transparent attempt to undermine the claim that the Fed helped “save the economy,” with little basis in fact. (This argument is essentially a “painful unwinding” scenario about Fed large-scale asset purchases and rate reductions.)

*Percentage losses are low compared to those in the stock market, which do not even offer a fixed income, generally resulting in a larger risk of capital losses.

The grounds in my opinion for greater pessimism about the macroeconomic impact:
*Bonds are important assets for some institutions that serve the middle class, such as pension funds and mutual funds, which require low-risk investments.

*The emerging market problem, though itself largely confined to resource-intensive exporters, adds to the breadth of overall bond-market losses.

*Borrowers—in this case, large businesses—are usually the party to a loan that is hurt most by a default. The implications of financial stress in the nonfinancial business sector–including weakened demand for new issues–can be large for investment spending, and hence for private-sector employment.

*The period of bond-market problems has been protracted, hitting one country and issuer after another

*Though losses have been occurring in the overall investment-grade market, the main component of the rise in yields has been a change in the spread between yields in this category and the less-risky investment grade category, which indicates a change in risk premia, rather than, for example, the Keynesian term premium for long-term securities in general.


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