Once upon a time junk bonds yielded 12-15% on a regular basis and not without reason. After accounting for average losses of about 5% on a long term basis—plus inflation, taxes, illiquidity and real returns—-double-digit yields made good sense financially.
After more than a decade of financial repression by the Fed and other major central banks, however, junk bond yields have fallen to the 5-6% range. Such rock-bottom yields, of course, are completely uneconomic and barely cover the risk of loss—-let alone inflation, taxes and the rest. So you would think that bond fund managers would go on strike, forcing yields back into at least a minimum zone of rationality.
Needless to say, you would be wrong. As highlighted in the Bloomberg piece below, fund managers are still insisting on a 10%+ return, but not by buying fewer over-valued junk bonds. No, they are just buying them on leverage in order to goose the yield on their own capital at risk.
Some Wall Street genius at Citigroup has even calculated that leveraging junk bonds at 2.3X is a better trade than leveraging US Treasuries at 8.1X. Is this fool serious? Has he not noticed the massive inflow of yield-starved investors into bond funds during the last half decade—-at a time when Wall Street dealers have drastically reduced their own trading inventories owing to Dodd-Frank regulation; and, also, due to the possibility that they may have actually learned something about the danger of leveraged inventory during the September 2008 meltdown.
In any event, the premium for illiquidity should be going up on account of reduced dealer capacity and a massive growth of bond mutual funds—-which, by the way, amount to demand deposits on the funding side and roach motels on the asset side; that is, the bonds go in during the boom but have no way to get out during a bust when investors dump their holdings en mass.
Unfortunately, the Fed’s massive bid in the bond market—what $3.5 trillion of government and GSE debt purchases since 2008 amounts to—has prevented price discovery from reflecting this new reality.
