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Junk Bond Issuance Soars Ahead of Expected Fed Rate Hike

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Are Wall Street’s fixed income underwriters inflating their sales figures ahead of a potential rate hike by the Federal Reserve later this month?

It sure seems like it, because junk bond issuance soared to $26 billion in November –- more than double October’s levels, according to Bloomberg data. Junk bonds, also known as “high yield debt,” carry a credit rating of BB or lower by Standard & Poor’s or Ba or below by Moody’s. Over the past few years, there’s been a boom in high yield debt issuance.

Since 2010, a whopping $1.97 trillion in newly created high yield corporate debt has been issued, according to Dealogic data. High risk borrowers have clearly taken advantage of low borrowing rates while yield hungry investors have snapped up the debt in search of higher yields.

The SPDR Barclays High Yield Bond ETF (JNK) carries an SEC yield of 7.10% while the more conservative iShares iBoxx Investment Grade Bond ETF (LQD) is at 3.59%. Despite its higher yield, however, JNK has underperformed LQD by more than 6%. Over the 12 months through December 3, JNK lost 4.73% while LQD gained 1.34%.

The current spread or difference between lower and higher quality debt is about 6.5%, down from as much as 9.45% previously, suggesting that bond investors are getting more selective about the credit quality of the fixed income they’re buying. (Although junk bonds command higher yields versus investment grade debt, they also come with higher default risk.)

But if the Federal Reserve hikes short-term interest rates at its next meet in mid-December — for the first time in more than nine years — junk bonds are less likely to feel the sting because the higher yields they pay will generally offset some of the impact of the drop in bond prices. Still junk bonds, especially short-term issues, could feel the sting as short term rates rise.

Those investors who are concerned about the impact of rising rates might consider the ProShares Short High Yield Bond ETF (SJB), a bear fund that aims to perform 100% opposite the performance of U.S. junk bonds. If high yield debt falls 1% on a given trading day, SJB is designed to rise in value by 1%.

While the Fed’s target inflation rate of 2% is important, the market’s current expectations for inflation are noticeably depressed. For example, the difference or spread between the yields of Treasury inflation protected securities (TIPS) and Treasury notes shows that bond investors expect inflation to average just 1.3% over the next five years. Is that too low?

Regardless of what the market thinks, a lack of inflation, as reflected in the Commerce Department’s core Personal Consumption Expenditures Price Index that which excludes food and energy and is the Fed’s favorite inflation indicator — will determine how quickly the Fed will push rates higher. And that in turn will impact the future performance of bond prices, including junk bond prices.

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