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Discovering that the U.S. Federal Reserve is buying not just government bonds but also corporate bonds and mortgage-backed securities is pretty shocking. Finding out that the Fed’s also buying ultra-risky exchange-traded funds is downright appalling.
For the Fed to buy equities is, in itself, problematic. The Federal Reserve was already artificially propping up the stock market through a massive bond-buying program. This is what’s now known as QE Infinity, even though Fed Chairman Jerome Powell refuses to recognize it as such.
Now the Fed’s adding ETF’s to the buying spree, so the clear message here is that buying bonds and mortgage-backed securities won’t be enough to keep the fragile economic structure from collapsing.
Corporate stock-share repurchases held up the stock market for years, but now this practice is frowned upon because these companies are receiving federal bailout money. The taxpayers want corporations to spend these funds on essential services that will benefit the public, not stock buybacks to boost share prices.
So, the Fed can’t count on companies buying their own shares for now. Consequently, America’s central bank has decided to just go ahead and start buying shares of exchange-traded funds – lots and lots of them.
They’re not buying shares of companies like Apple or Microsoft, though I wouldn’t be surprised if that’s the next phase of the plan. For now, the Fed plans to purchase a basket of investment-grade and high-yield bond ETF’s. High-yield bonds are commonly known among the financial community as junk bonds, and for good reason.
Note that the ETF ticker symbols include names like JNK and SJNK. It’s as if the ETF managers are mocking the shareholders. They’re practically telling you that their funds are junk. “High yield” means high risk, and the Federal Reserve is behaving recklessly in purchasing these assets.
Junk bonds, also known as speculative-grade bonds, are defined by Standard & Poor’s as bearing a credit rating lower than BB. These represent an interest in companies that are struggling financially and that carry a high risk of default. In other words, buying a junk bond means that the yield is high but you’re taking on a serious risk that you’ll lose your entire investment.
Therefore, it’s extremely risky to own shares of junk-bond ETF’s. For instance, the prospectus for the iShares iBoxx High Yield Corporate Bond ETF (HYG) clearly states, “Debt issuers and other counterparties may be unable or unwilling to make timely interest and/or principal payments when due or otherwise honor their obligations.”
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It further explains that “Securities that are rated below investment-grade… may be deemed speculative, may involve greater levels of risk than higher-rated securities of similar maturity and may be more likely to default.”
David Albrycht, the chief investment officer at Newfleet Asset Management, succinctly summed up the only reasonable conclusion: “The Fed may end up losing a ton of money in this program.” And of course, the Fed is funneling taxpayer dollars so their loss is really our loss.
Worse yet, the Fed’s risky junk-bond gambit is only encouraging traders to imitate this type of behavior. As you can see in the chart above, investors started bidding up the iShares iBoxx High Yield Corporate Bond ETF immediately upon hearing the news of the Federal Reserve’s intention to buy it.
Perhaps these investors need a refresher in what happened during the junk-bond bubble and collapse of the late 1980’s. As reports surfaced in 1989 of junk bonds losing 20% of their value in a single day, horrified portfolio manager Robert S. Dow observed, “It’s the crème de la crème. This is the stuff that nobody ever worried about.”
When nobody’s worrying, that the time for informed investors to start worrying. And when the Fed’s buying assets that belong in the junk pile, that’s your signal that the end is beginning.
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