How the Fed Is Pushing Investors to Buy Junk Bonds

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With no end in sight for the Federal Reserve's fixation on low interest rates, a likely scramble for yield has intensified worries about dangers ahead for junk-bond investors.

The Fed's announcement on Wednesday that it will tie near-zero rates to specific unemployment and inflation rates sent a clear signal: Those looking for return in cash and fixed income won't get it from conventional debt instruments like Treasurys and money market funds.

Instead, they'll have to turn to assets like stocks, commodities and higher-yielding bond products that carry greater return - and greater risk. (Read More: Fed to Keep Easing, Sets Target for Rates)

"The market is thirsting for yield and the Fed is pushing people to do things like this," said Lawrence G. McDonald, who as head of LGM Group specializes in junk-bond trading. "So big asset managers are reaching, reaching, reaching and companies know this and are issuing, issuing, issuing all this crap."

The big losers could be not only junk bond issuers but also pension funds and retail investors as well.

Of course, the thirst for yield is nothing new, as the Federal Reserve has had its boot on the throat of the rate markets since the early days of the financial crisis in 2008.

However, the central bank Wednesday it will keep rates at zero at least until the unemployment rate, currently at 7.7 percent falls all the way to 6.5 percent, and the rate of inflation hits 2.5 percent. Fed Chairman Ben Bernanke said even reaching those targets is no guarantee the Fed will back off its zero interest rate policy, or ZIRP. (Read More: Game Changer? Jobs Report 'Isn't Much News at All')

Stock market traders actually reacted with some trepidation at the accompanying news that the Fed will buy $45 billion worth of Treasurys each month in a move that will mean a total of $85 billion in monthly asset purchases and a balance sheet expansion likely to go well past $4 trillion.

Traders have been saying they are dismayed the Fed isn't doing even more and are worried in any event that the purchases, known as quantitative easing, are losing their impact.

The biggest jolt, then, could come in fixed income, where high-yield bonds - in that category because they also possess greater risks - will be in even greater demand.

Companies recognizing an opportunity to take on debt at low rates issued a record $293 billion in junk bonds through November, easily eclipsing the record $271 billion for all of 2010, according to Citigroup. Coupons for speculative double-B bonds are at 5.6 percent, near the record low of 5.3 percent.

McDonald pointed out that 40 percent of high yield bonds are trading above their call price, and he worries that these trends will end badly once supply outstrips demand, and when some shaky companies issuing low-cost debt start to default.

"There's no question that the punch bowl is about to be taken away and people are going to be left holding the bag," he said. "When it comes time for a sale, it's going to be an elevator shaft, because there are not enough buyers to support the price action on the way down." (Read More: When Will the Bond Bubble Burst?)

This isn't just a matter of Wall Street bond traders at risk, either.

Ordinary pension funds, which rely on getting yield from conventional instruments that carry lower levels of risk, are apt to be forced further out on the risk curve in an effort to generate the 8 percent return that most require to stay viable.

"Think about conservative investors, think about pension plans. How do we balance a portfolio and get to our required rate of return with interest rates sitting at zero?" said Marc Doss, regional chief investment officer at Wells Fargo Private Bank. "It's going to take investment skill to actually try and generate decent return without taking too much risk."

For Doss, the game now is about playing along and not fighting the Fed's push to risk. But he sees the better bets in equities and commodities as well as high-yielding municipal bonds, a group considered taboo not long ago but which continues to draw investor interest.

"We're really worried about investors in bond funds. They don't realize you're going to lose 20 to 30 percent in those funds when you actually just normalize those rates," he said. "That transition won't be easy."

Where the Fed has acted as a market-supporting force by buying U.S. government debt, large dealers had been stepping in to keep the corporate debt markets flowing.

But with new banking regulations coming on line, many of those on Wall Street with deep pockets won't be able to participate.

Already over the past month there has been some deterioration in the high-yield market. Junk bond mutual funds saw about $3 billion in outflows for November.

"Clearly, technicals deteriorated in November," Citigroup fixed income analysts said in a report. "Since mid-September, clients have been consistent net sellers."

Still, exchange-traded funds that focus on high-yield have held their ground.

The iShares iBoxx High Yield Corporate Bond Fund has been on an almost unfettered ride higher since the March 2009 bottoming of risk markets, and is back around its September 2008 levels.

That was the month Lehman Brothers collapsed and sent Wall Street and the American economy into its worst tailspin since the Great Depression.