Junk Bond Demand Soars: Is This the Time to Be Raising Cash?

by Emma Davis
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Submitted by Emma Davis of Investment Contrarians as part of our contributors program.

By Sasha Cekerevac

With the aggressive monetary policy plan implemented by the Federal Reserve in place, it’s not just retirees who are seeking yield and can’t find it; large institutional funds are in the same predicament.

I believe that one of the goals of the Federal Reserve in enacting its current monetary policy plan is to entice investors into assets other than cash. Simply having cash sitting idle cannot help the economy. However, yields are so low that many investors are hunting for income in dangerous places.

Just this past Tuesday, the yield on Barclays U.S. Corporate High Yield index (junk bonds) dropped below five percent. This represents a record low and is the first time in its history of 30 years that the junk bond index has seen rates fall to such low levels. (Source: Burne, K., “Yields on Junk Bonds Reach New Low,” Wall Street Journal, May 8, 2013, accessed May 9, 2013.)

In addition to this record-breaking threshold, this junk bond index yielded six percent only this past January, which shows the massive amount of capital being put to work. The monetary policy by the Federal Reserve is leaving institutions with so much demand for yield that they are piling into any marginal investment, which could end up costing investors.

Even more esoteric, investors are moving into emerging markets such as Cote d’Ivoire, which has seen yields on its eurobonds (bonds denominated in U.S. dollars outside of America) cut in half over the past year. (Source: “Africa’s bond markets: Kings of the wild frontier,” The Economist, March 2, 2013.)

Risks are substantial for investors hunting for yield in this environment engineered by the Federal Reserve, as Cote d’Ivoire was involved in a civil war not too long ago, not to mention it has a history of defaulting on its debt. Yet, international investors are piling money into very risky investments.

A great example of the heavy demand, Zambia was looking to issue $500 million in eurobonds, yet received $12.0 billion in orders. The 10-year bonds were ultimately issued for a total of $750 million at a yield of 5.4% to investors from all over the world.

The additional yield that many are seeking might come at a large cost in a few years. The monetary policy program by the Federal Reserve will not last forever, and when this tide shifts, it will reverberate throughout a variety of markets.

The best time to sell is when you can, not when you have to. While I still advocate stocks over fixed income, a shift by the Federal Reserve in beginning to reduce monetary policy stimulus will hit all markets. At that point, cash is king.

A prudent plan would be to begin reducing some equity holdings, while having stops in place to be able to exit the remaining positions and raise funds during the next sell-off, which I believe will come this fall.

While the Federal Reserve is trying to improve economic conditions through its monetary policy program, there will be costs associated with this action. Namely, individuals and institutions that are making risky investment decisions in the hunt for yield might pay a very large price over the next decade.

This article Junk Bond Demand Soars: Is This the Time to Be Raising Cash? was originally published at Investment Contrarians

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