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The Economist: Who Will Be Left Holding the Bag With Junk Bonds?

By John Morgan   |   Friday, 18 Oct 2013 02:15 PM

The junk bond market has enjoyed a renaissance as rates close to zero have pushed investors to make riskier investments, but there may be pitfalls ahead as a lack of liquidity and issuer escape clauses could ruin the party, according to The Economist.

The junk market is now bigger than big, about $1.7 trillion, and The Economist reported almost half of all corporate bonds are classified as “speculative,” or junk.

The phenomenon is a world-wide one. By an estimate from Hermes America, the United States represents 57 percent of the junk market, and Europe has grown to 27 percent.

Editor’s Note: 5 Reasons Stocks Will Collapse . . .

Junk bonds have allowed companies to have an alternative to bank loans at a time when banks were unwilling or unable to make loans, and the low rates of recent years have enabled companies to refinance their debt cheaply.

But, as is often the case, when investments become too popular, there could be trouble ahead.

The Economist reported that though the market has doubled or tripled in size since 2008, liquidity has grown tighter as regulatory restrictions have forced banks not to hold as much bond inventory as they previously had.

“In other words, if investors ever lose their current enthusiasm for high-yield bonds, they will find it much harder, and probably costlier, to offload them,” The Economist reported.

At the same time, junk yields have gone down due to their popularity, which eventually could make them a less attractive investment.

Perhaps worse, The Economist noted as much as three-quarters of high-yield bonds have a “call option” attached to them, which lets issuers repay the debt if it reaches a target price. If a bond gets close to the callable price, it is unlikely to appreciate much further, which puts a cap on the profits investors can make.

Barron’s reported the average junk-bond yield has fallen below 6 percent for the first time since late July, and posed the question whether 2013 could end up being a “coupon clipping year” for junk bonds.

The investor site 24/7 Wall Street cited a Bloomberg estimate that hedge funds have now piled on the greatest share of the U.S. junk-bond market since the 2008 financial meltdown. That development is “raising concerns that bets with borrowed cash will accelerate losses if and when the Federal Reserve stops printing record amounts of money,” the site reported.

“The problem is that there could be a junk-bond debacle that could truly threaten the financial system if all the selling starts around the same time,” 24/7 Wall Street predicted.

Editor’s Note: 5 Reasons Stocks Will Collapse . . .

Related Stories:

Junk Bond Market Warning of Stock Market Crash

WSJ: Investment-Grade Bonds Are a Better Bet Than Junk Bonds Are

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