STAFF NEWS & ANALYSIS
Corporate's Turn: As Yields Drop, Investors Plunge Down the Rabbit Hole of Systemic Risk
By Staff News & Analysis - March 22, 2013

Investors Beware: Market Risks Today Are Higher than Ever … It's time to start worrying about the bond market … After the shot across the bow in 2008, you might have expected that regulators and market participants would use the experience to change for the better, to become more prudent, and to reduce the sorts of risky behaviors that almost crashed the entire system … – PeakProsperity.com

Dominant Social Theme: Bonds are safe because they are issued by the government.

Free-Market Analysis: Actually, it is going to end very badly. The Federal Reserve is the most powerful bank in the world and it has proven it once again by powering up the financial markets to all time highs.

As this article points out, stocks are for show and bonds are for dough – because the bond market is so much bigger than the stock market.

Many people do not understand bond market risks because the idea sticks in their mind that when it come to government bonds, the principle is supposed to remain intact and be returned. But bonds of course can lose significant value, in which case they are said to be trading at a discount.

Today, given the celebratory atmosphere surround the stock market, many bonds may be trading at a premium and thus, investors are traveling down the yield curve to find bonds that are trading below face value – at a discount.

This article excerpted above does us the service of pointing out that yield seekers are especially prevalent in the corporate bond arena. Here's more from the article:

To think that the Fed has all of this under control, that it can steer the consequences of an entire world of investment and speculation decisions to a normal and graceful ending, requires far more faith than I can muster.

The very idea that the worst-of-the-worst credit risks in the corporate world are now yielding less than 6% is even more absurd than anything that I observed during the height of the housing bubbles. Even the tiniest hiccup will wipe out the holders of those bonds, leaving them with, at best, pennies on the dollar.

Let me be very clear here: What I see now in the bond market is at least an order of magnitude riskier than anything I saw in the housing bubble, and if/when it pops, the effects will be far, far worse.

We have written previously about corporate bonds in terms of junk bond issuance. Recently there was a spate of articles about the return of the junk bond market. We found that curious and wrote the following:

Two issues need to be clarified about the current junk boom. First, it doesn't exist and second, you ought not to want it to.

The modern junk bond market, when it is really in evidence, is a multi-trillion dollar entity. A few deals do not a resurgent junk bond market make, no matter how hopeful bond-market writers want to be.

And this idea that the market – and its instrumentalities – are rebounding is as dangerous as it is pernicious. US central banks have dumped tens of trillions into the larger economy and most of this money is still trapped in banks that have yet to distribute it.

But be careful what you wish for. When these funds begin to circulate, central banks will be impelled to raise rates. This will cause a further recession and also reveal more fully the reality of the Modern Age – that the reign of King Dollar is over.

The dollar died in 2007-2008. Central banks the world over have continued the dollar reserve system only by flooding economies with currency. Monetization has substituted for solvency.

But that cannot go on forever. Once rates rise, countries like the United States will find it impossible to service debt. Debt service will begin to occupy most of the federal budget.

The point we were trying to make was not that junk corporate are not in demand but that the deal flow was not of booming proportions … and probably still is not, so far as we can tell. This is not the Age of Milken redux.

But as this article points out, bonds generally ARE in demand and once again as with the stock market people are taking on risk that they don't comprehend.

Blame it on the Fed. Keeping rates below real rates (whatever they may be) is nothing but a financial crime in our view. It tricks people into believing investments are safer than they really are.

In this case, just as the stock market has been inflated to risky heights by Fed money printing, so the bond market has inflated, with investors taking on more and more risk to find fixed income deals.

When the stock market finally implodes, as it inevitably will, the corporate bond market – junk and otherwise – is going to take a beating … to put it mildly. The difference will be that the flow of blood will be thicker and deeper. Sovereign bonds, of course, will not be immune, either.

Pain on pain. Agony compounded by previous years of low yield and increasingly low coupon issuance. It is going to be very ugly when the bond bust comes upon us.

You think it won't? Trees grow to the sky?

After Thoughts

Sell the market short? Just get out? At least don't chase yield. Remember, eventually metals will likely spike. There are options for those who are awake enough to see them …

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