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John Kinsellagh
John Kinsellagh
Articles (132) 

Investors Rush Back Into Junk Bond Market

Warning: what the Fed giveth, the Fed taketh away

February 08, 2019

Squeamish from a dramatic market rout late last year, high-yield bond investors are once again entering the junk market, courtesy of the recent rate increase reversal by the Federal Reserve. Many of these investors substantially increased the cash portion of their portfolios in December in response to steep declines in the market as well as continuing concern over the trade dispute with China, a slowing global economy and uncertainty concerning the direction of the yield curve.

According to Leveraged Commentary and Data, or LCD, a unit of S&P Global Market Intelligence, corporations with sub-investment-grade status have issued approximately $50 billion of bonds and loans since Jan. 10. This represents a dramatic increase from the $29 billion of junk bonds sold in November and December. Although investors' appetite for relatively high junk bond yields has rebounded, it still hasn’t reached the pre-October 2018 frenzy for these high-risk fixed-income vehicles.

For this round of financing, however, companies have had to sweeten the pot for investors. As they re-enter the junk market, investors have been allured by enticing offers from many corporations considered at the top of the lower-rated junk pyramid. In light of the low-rated debt as well as the ever-present risk of an economic downturn and slowing global growth, investors have demanded an additional level of protection. Accordingly, some corporations needed to add bondholder covenants, restricting the payment of dividends to shareholders as well as imposing limits on the ability to issue additional debt.

Many corporations who issued a significant amount of debt recently were forced to offer secured rather than unsecured bonds. Investors holding unsecured debt instruments are the last in line during a bankruptcy liquidation. Secured bonds seem to be the instrument of choice for high-yield junk investors. According to S&P Global Market Intelligence, in order to finance its acquisition of its aerospace components manufacturer competitor, Esterline Technologies Corp. (ESL), TransDigm Group Inc. (TDG) issued $3.8 billion of first-lien secured bonds, a record amount for this type of debt instrument. In light of investor demand for additional protection for the risk assumed, the company subsequently dropped a planned sale of $1 billion in unsecured notes and returned to market to sell $200 million in secured notes.

Perhaps the greatest risk for those enamored of high yields, is that there could be an unforeseeable change from the Fed’s current interest rate policy. Investors' recent shift back into risky assets, made with the same confidence exhibited during the bull market, could prove to be misplaced as well as illusory. Too many analysts overlook the fact the recent reversal by the central bank is not a return to the halcyon days of its decade-long zero-interest rate, easy money policies.

Any mitigation of risk for investors is now wholly Fed-dependent. Investors should note that prior to the recent reversal, Fed Chairman Jerome Powell‘s posture on rate increases was flexible and needs to respond on a “we’ll take it as it goes” policy for finetuning the money supply to match changing economic conditions.

Although, many may find Powell’s recent policy pronouncements more salutary than those comments made in the recent past, the current policy is not set in stone. The overall risk to junk bond investors with debt is the same for those re-entering the stock market. At some point, the Fed is going to give a clear signal to those who have re-entered risky asset classes that it will not countenance a return to a skewed risk-reward paradigm instilled by a decade of quantitative easing. One of the principal concerns for Fed policy is to be circumspect about not providing incentives for an asset class bubble.

Those jumping headlong back into risky assets with nary a concern should be mindful of the admonition: live by the Fed, die by the Fed.

Disclosure: I have no positions in any of the securities referenced in this article.

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About the author:

John Kinsellagh
John Kinsellagh is a freelance writer, former financial adviser and attorney specializing in civil litigation and securities law. He completed the Boston Security Analysts Society course on investment analysis and portfolio management.

He has served as an arbitrator for FINRA for over 25 years resolving disputes within the financial services industry. He writes primarily on financial markets, legal and regulatory issues that impact the investment community, and personal finance.

He is the author of "The Mainstream Media Democratic Party Complex" and "Election 2016," both available on Amazon. Follow him on Twitter @jkinsellagh.

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