Bond hubris overwhelms Fed in riskiest credit-market sectors

Bond investors trying to divine when the Federal Reserve will reduce its unprecedented monetary stimulus are increasingly looking to the riskiest parts of the debt market, which are booming like before the financial crisis.

The amount of loans made this year that lack standard protections for lenders exceed the all-time high set in 2007, and only one other time have investors pumped more money into funds that buy lower-rated loans than they did last week. Bonds rated in the lowest category of junk accounted for the greatest percentage of speculative-grade offerings last month since 2011.

While Fed policy makers say employment and inflation will be the primary determinants of when and by how much they reduce the $85 billion a month being pushed into the economy every month through bond purchases, signs of excessive risk-taking are likely to also play a part. Chairman Ben S. Bernanke and Fed Governor Jeremy Stein have cited the potential for continued so- called quantitative easing, or QE, to disrupt financial markets.

When to reduce “seems to be a risk-management issue as opposed to a pure economic issue because the Fed hasn’t really met its mandates with respect to employment gains or with inflation,” Christopher Sullivan, who oversees $2.2 billion as chief investment officer at United Nations Federal Credit Union in New York, said in an Aug. 7 telephone interview.

Bernanke’s Experience

Bernanke is aware of the risks to the economy, after leading the Fed through the worst financial crisis since the Great Depression, when financial firms posted credit losses of more than $2 trillion as the subprime-mortgage market collapsed, the Standard & Poor’s 500 Index of stocks fell by more than 50% and home foreclosures rose to a record.

“Having experienced the damage that asset-price bubbles can cause, we must be especially vigilant in ensuring that the recent experiences are not repeated,” Bernanke warned in a 2010 speech. “We must remain open to using monetary policy as a supplementary tool for addressing those risks.”

Fed policy makers next meet to decide monetary policy on Sept. 18. That’s when they will likely trim their monthly bond purchases to $65 billion, according to half the 54 economists surveyed by Bloomberg from July 18 to 22.

Concern that the Fed may reduce its stimulus sent bond markets plunging, pushing borrowing costs higher.

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