US Markets

Drunk on Junk: Why We're Rushing to Risk

Zak Kendal | Cultura | Getty Images

Junk is all the rage these days as Federal Reserve policy pushes investors away from safety and into the far reaches of the risk spectrum.

The highest-yielding bonds—which are by extension the lowest-quality—are in the midst of a record year for issuance, with $62 billion hitting the American market so far this year, according to Dealogic.

That's a 16 percent increase over the same period a year go and 13 percent of the total fixed income outlay this year. The rush to junk comes on the heels of a $100 billion spree in 2012 and is well above the pace of the 2006 and 2007 issuance just prior to the financial crisis that crashed the markets and nearly took down the entire global economy.

While investors feel safe in high yield both because of its income stream and the still-low—but slightly rising—default rates, there is rising concern that there could be trouble ahead.

"Corporate credit and high yield bonds are somewhat exuberantly and irrationally priced," Bill Gross, managing director of bond giant Pimco, said in his monthly newsletter for March. "Spreads are tight, corporate profit margins are at record peaks with room to fall, and the economy is still fragile."

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In his position at Pimco, Gross helps run the firm's Total Return Fund, the largest by assets in the world at $285.6 billion. The fund has returned 7.3 percent year to date, more than doubling the benchmark it has routinely beaten over its life. In all, Pimco manages $2 trillion for clients.

Gross said now is not the time for a wholesale dump of high yield, but investors should realize that risks are rising while returns could start falling. He advises that "recent double-digit returns are unlikely to be replicated."

Spreads between high-yield bonds and their government debt counterparts are at post-crisis lows, with the 5.13 percentage points the tightest since 2007.

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History has shown that when issuance hits elevated levels and spreads tighten, returns tend to start heading lower. For example, Barclays Corporate High Yield Index gained just 1.3 percent in January, a low return when measured against other indices so far this year.

The Federal Reserve fits into the junk bond picture because it has forced investors to take on more risk to get yield through its zero interest-rate program.

While the central bank's bond-buying has helped boost stock market prices it also has driven down fixed income yields, especially hitting investors holding bonds for coupon returns as well as savers in plain-vanilla money market and savings accounts.

"It is what central banks encourage and to date it has been successful. If and when that support dissipates or if the economy remains anemic, investors should be cautious and temper their enthusiasm," Gross said.

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In a more accelerated downturn, the results of the rush to high yield could be even more ominous.

"We're already in a bubble," said Peter Schiff, CEO at Euro Pacific Capital and frequent Fed critic. "The question is, when does it burst? The Fed is...repeating the same mistakes it made with the housing bubble. When this bubble bursts it's going to dwarf the economic damage of that."

Recent comments from Fed Governor Jeremy C. Stein helped stir concern over a possible credit bubble.

"My reading of the evidence is that we are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit," Stein said in a speech earlier this month.

He added that the damage from losses on junk bonds could be "confined and therefore less of a policy concern" but warned that "waiting for decisive proof of market overheating may amount to an implicit policy of inaction on this dimension."

Investors may become more cautious as even more supply hits the market and yields compress still further.

"You may get spotty deals in high yield, but it doesn't necessarily mean you're at the end of their cycle," said Robert Tipp, chief investment strategist at Prudential Fixed Income. "It may just mean there are individual issues and you need to be selective. This market has come a long way."