11 February 2010

Investors Chase Junk Bonds

Rates on risk free investments, like Treasury bonds, remain dismally low.

Offerings of investment grade bonds (unsecured first priority debt issued by big businesses that aren't financially distressed) are also way down. Companies that issue investment grade bonds are asking for 90% less funds they than the average so far this year. This is despite the fact that the rate of return on investment grade corporate bonds is a dismally low 1.39%, which comes close to a negative return after adjusting for inflation.

With good investment options looking unattractive, investors are starting to look at risker investments, junk bonds, which are between ordinary debt and stockholders in priority in most cases, or are ordinary debt in companies at high risk of failing. Junk bonds are defined as those rated below Baa3 by Moody’s Investors Service and below BBB- by Standard & Poor’s.

Interest rates on junk bonds are rising as a result. Higher interest rates are making more junk bond funds available to companies that need funds, but are also making it harder for companies in trouble to be able to afford to borrow money.

Put another way, the bond market is tell us that: (1) business is slow for healthy companies who can't find productive uses for cheap credit and so aren't asking for new investments, and (2) the likelihood that marginal companies will fail is increasing.

Normally, higher interest rates on junk bonds also cause stock market prices, at least for junk bond issuers, to fall.

No comments: