Tapering plan drives investors into riskier debt

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Traders work in the S&P 500 options pit at the Chicago Board Options Exchange.

The Federal Reserve's plan to end quantitative easing, in part to prevent financial bubbles, is in fact driving investors into riskier corners of the debt markets.

While the safest bonds have sold off hardest since Ben Bernanke, Fed chairman, set a timetable for tapering its monetary stimulus, the best-performing fixed-income assets have been the lowest-rated junk bonds.

Money has also poured into loans in the past three months, with the result that many borrowers no longer have to provide customary investor protections.

(Read more: US bonds fall on Fed tapering fears)

"Investors are so afraid of rising rates that they are trading off rates risk by taking on more credit risk," said Ashish Shah, head of global credit at asset management group AllianceBernstein.

Junk bonds rated triple-C, the lowest tier possible, are the only corporate bonds to have generated positive returns since Mr Bernanke's June 19 press conference, when he said the Fed would most likely start scaling down its Treasury and mortgage purchases this year and wind them up by the middle of next.

Riskier bonds tend to offer higher interest rates and so repay their purchase price more quickly – a measure called "duration" – something that has become critically important in a rising interest rate environment. Longer duration bonds fall more sharply when market interest rates rise.

(Read more: Worst case for Fed taper: mere market 'indigestion'?)

Investment grade bonds have lost 1.3 percent and double-B rated junk bonds have shed 0.8 percent since June 19, compared to a positive return of 0.9 percent for the triple-C class.

The extra yield, or spread, that triple-C investors are demanding over risk-free Treasurys has narrowed by 20 basis points over the same period, compared to 5 basis points for investment grade corporate bonds.

Bankers have been emboldened by the demand for high-yielding investments to seek more advantageous terms for borrowers.

Matt Duch, a portfolio manager at Calvert Investments, said there had been an increase in borrowers seeking to add high leverage and "payment-in-kind toggle" deals, which give borrowers the option to pay lenders with more debt rather than cash.

"The strong demand for low-rated high yield could be fostering a generation of paper with subpar structures," he said. "That could definitely be a problem in the future should defaults pick up or financing suddenly become less available."

More from the Financial Times:

Sell-off as markets expect early Fed move
Foreign investors rapidly sell Treasuries
Other demand for Treasuries may wane

Some of the most aggressive deal structures are being proposed in the loan market, which is used for financing leveraged buyouts. There have now been 61 consecutive weeks of inflows into mutual funds and exchange-traded funds specializing in loans, according to Lipper, adding up to $39.1 billion of new money chasing investment opportunities. Some $11.6 billion has been added since June 19.

Because loans offer a floating rate of interest, they are seen by investors as insulated from the risks of rising rates as the Fed tapers QE.

(Read more: Dovish or hawkish? Fed message could get markets flying)

The US software group BMC, which was acquired by a private equity consortium led by Bain Capital and Golden Gate Capital, this month sold $5.86 billion of debt with only light covenant protections for investors and with an unusual provision giving more freedom to sell assets before repaying lenders.

The use of "covenant-lite" loans has re-accelerated since Mr Bernanke's remarks, accounting for 58 percent of all loan issuance so far this month. That puts August on course to be the second highest month ever, after January 2013, according to S&P Capital IQ.