The Federal Reserve's got the bond market right where it wants it: Issuers are salivating to offer low-priced debt, and investors are snapping it up in record amounts.
The Fed's bond-buying program, known as QE-2, has no doubt led investors to longer-term bonds in the hunt for yield — and into riskier assets.
Short-term Treasurys are near all-time lows, with the six-month T-bill earning just 0.11 percent last week. That creates a large gap for the pension funds, mutual funds and endowments seeking returns of around 8 percent.
There's no question asset managers are taking more risk to meet their return targets. To eke out higher returns, they're fleeing Treasurys for other asset classes — investment-grade debt, junk bonds, and even distressed debt.
The riskier the debt, the smaller the market. Total US Treasury debt stood at $9.1 trillion compared to $2.7 trillion for investment-grade debt, $924 billion for junk bonds and $160 million in distressed debt.
It causes a domino effect: As investors crowd into the riskier asset classes, they pull returns down, making it even harder to meet meet yield targets.
Migrant investors are being crowded out even as total investment-grade issues increased by 10 percent in the first quarter and high-yield issuers added $84 billion for the highest first quarter on record.
Kathleen Gaffney, who manages a $20 billion fund at Loomis Sayles, says moving up the curve requires managers to "tread with care." Investment-grade bonds don't pay much of a premium for credit risk.
That makes them the most directly sensitive to the Fed's rate increases, Gaffney noted, so investing can be a bit tricky. She prefers bonds in areas of the economy that have yet to improve, such as home building.
But even bonds for investment grade-rated home builders like Toll Brothers are trading above face value.
Some high-yield bonds are not only trading like better corporate credits, but they're being sold to investment-grade desks as well.
Craig Arcella, a partner in the capital markets practice at Cravath, Swaine & Moore, said these credits could be looked at as "rising stars," not "fallen angels" as they were known when they first got downgraded.
For example, of the investors who purchased CIT Group's first post-bankruptcy bond, 40 percent of its book comprised by investment-grade buyers because they expected an upgrade.
Other names lincluding Ally Financial, MEG Energy, Chesapeake Energy and Ford Motor Credit Corp., have seen crossover investors as well.
In the more traditional high-yield market, the most actively traded bonds are those with CCC-ratings. With CCC-rated bonds hardly earning more than B-rated debt, it would seem that owning those bonds wouldn't be worth the risk.
Perhaps investors are satiated by the fact that defaults for that tier stand at only 3%, down In distressed debt — where spreads are still low but defaults are higher — these lighter covenants could spell disaster.
Even so, that's not keeping traditional investors from creeping into those bond waters. But it is causing well-known distressed investors to consider the froth.
Oaktree Capital Management's Howard Marks partially returned investors' money this year, citing a lack of prudent investment opportunities. Short-term Treasury yields were forcing investors investors to choose between return and safety, Marks wrote to investors, with most choosing returns.
As a result, the market was making investors into handcuff volunteers — participating in the market, only because they didn't have a choice.