Bond hubris overwhelms Fed in riskiest credit-market sectors

‘Pattern’ Detected

Fed Governor Stein said in a February speech that investors in company debt had been engaging in “a fairly significant pattern of reaching-for-yield behavior.”

At 7.4%, the jobless rate remains above the Fed’s 6.5% target, while the rate of inflation is below 2.5%, levels policy makers said would trigger a reduction in its bond purchases.

“Unlimited QE without the risk of any kind of tapering or end in sight perhaps is unnecessary given that risky assets are somewhat elevated and that the downside economic risks that existed at the end of last year, such as Europe and the fiscal cliff, have clearly gone away,” Dominic Konstam, the head of interest-rate strategy at Deutsche Bank AG in New York, said in an Aug. 2 telephone interview.

The firm is one of the 21 primary dealers of government securities that trade with the Fed.

Bonds rated CCC and lower lost 2.4% between May 22, when Bernanke said the central bank was considering reducing or ending the asset purchases, and June 19, when he reiterated those comments.

Risk Rebound

Since then, the debt has gained 3.5% as yields fell to an average of 9.79% on Aug. 7 from a seven-month high of 10.6% on June 25, Bank of America Merrill Lynch bond indexes show.

Most risk assets “have probably retraced a good 75% on average of the widening that occurred in the late May and June period,” Michael Materasso, co-chairman of the fixed- income policy committee at Franklin Templeton Investments in New York, said in an Aug. 5 telephone interview.

The firm, which oversees $365.7 billion of bonds, has been buying higher-rated company debt, municipal bonds and securitized credit, Materasso said.

With slow global economic growth, people are “looking for yield and investors are making decisions that they normally wouldn’t,” he said. “They can get burned pretty badly given how low yields are in the absolute sense, as well as in some areas how tight credit spreads are compared to where they could be in a more credit-deteriorating environment.”

Speculating ‘Serpent’

Investors convinced the Fed is going to keep interest rates low through 2016 are more willing to take risk and add leverage, forcing the central bank into a balancing act to encourage lending while preventing bubbles, according to Lawrence McDonald, senior director for credit, sales and trading at Newedge USA LLC.

“If you’re too accommodative, the serpent in the market will come back and start speculating really quickly, and that’s what’s happened to some extent,” he said in an Aug. 5 telephone interview. “They’re watching that like a hawk.”

McDonald, the author of the book, “A Colossal Failure of Common Sense,” on the 2008 demise of Lehman Brothers Holdings Inc., is forecasting the Fed will taper in September.

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