When even junk bonds get riskier!

Wed, 10 Nov Pre-Open

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When was the last time you heard investors in junk bonds complaining that they were risky? Even the thought seems ridiculous given that junk bonds by definition are supposed to be very risky investments. However, the Wall Street Journal reports that hedge funds managers in the US are getting out of these instruments. The US Fed's latest round of QE has ensured that large doses of cheap money keep coming into the system. As a result speculation in the junk bond markets have gone beyond the risk appetite of hedge fund managers. In fact retail investors seem to be now flocking to them in search of higher returns! Unfortunately policymakers in some of the largest economies do not see the crisis evolving here. But the US is not the only one to be blamed.

Internationally, the success of the unprecedented pump-priming has accelerated a shift in economic influence. China for instance is now being looked upon as the next source of cheap money by speculators globally. Readers may recall that China had offered a 4 trillion yuan stimulus package in 2008 when the global economy was gripped by recession. Once again when similar signs are confronting the developed nations, China is expected to come to their rescue. Creating jobs and demand for the wares produced by the developed economies has now been left in its court.

However, the Chinese are more reluctant to give in to the pressure this time around given the pitiable state of their dollar investments. Quoting the Chinese Finance Minister "Around the world we have US$ 10 trillion of hot money flowing around, more than the US$ 9 trillion in hot money at the beginning of the global financial crisis." Thus the Chinese are not oblivious of the risk creation that the US Fed is engaging into. In such a scenario the Fed may be left with little option but to keep the QE tap running itself until it can get hold of its finances.

Coming back to the junk bonds, their prices are reportedly at three year highs. As the cheap money flows in, the credit-quality of the companies selling debt is falling. Also they are all paying increasingly lower interest rates. Despite that there is high demand for such instruments amongst speculators.

The only conclusion one can come to from this is that creation of asset bubbles in emerging markets is but a certainty. If the most undesirable investments continue to attract fund flows, the relatively safer and attractive assets here are bound to seek higher valuations. To the extent that even retail investors may get lured into buying them at very risky levels.