On Thursday, knowing that a three-day Easter weekend was coming and
the attention of the public would be elsewhere, the Federal Reserve
announced that it would allow two of its emergency lending programs to
begin buying junk bonds. Those are bonds with less than an
investment-grade credit rating, meaning they have a greater likelihood
of defaulting. The Fed is not simply accepting junk bonds as collateral
for loans, it will actually be buying junk bonds — potentially hundreds
of billions of dollars of them.
Two of the popular junk bond
ETFs, iShares iBoxx High Yield Corporate Bond ETF (symbol HYG) and SPDR
Bloomberg Barclays High Yield Bond ETF (symbol JNK) closed the trading
day on Thursday up 6.55 and 6.71 percent, respectively, on the
announcement. Those ETFs had been plunging in price for most of the
month of March.
For years now, prudent investors have been
forgoing risky investments like junk bond ETFs and accepting a much
tinier yield on U.S. Treasury securities. Now, high rollers like hedge
funds that bought junk bonds and junk bond ETFs and received the higher
yields, are getting bailed out of these risky bets. The markets will
now, going forward, price junk bonds on a closer plane with Treasury
securities, assuming the Fed will not let them fail.
This is
effectively killing the pricing mechanism of Wall Street. A U.S.
Treasury note has the unconditional guarantee of the U.S. government to
make the timely payment of interest every six months and pay the
principal at maturity. Junk bonds are backed by nothing more than
deeply-indebted corporations, which can, and do, frequently file for
bankruptcy protection, making their bonds sometimes sell for pennies on
the dollar. But going forward, junk bond ETFs will be priced on the premise
that the Fed may ride to the rescue.
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