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Another Red Flag

May 13, 2013

I want to give you a definition, by picture, of what I mean when I suggest that risk is not being appropriately compensated in our financial markets these days as a result of massive manipulation, particularly in the area of interest rates. Economics 101 assumes that when you loan money (buy bonds) your return is a factor of risk and duration.

Barclays High Yield Fund is a nice title, but it is actually a corporate junk bond fund. Because our monetary policy has forced individuals and entities who need to receive a certain level of return (yield) into riskier debt, the junk bond business has experienced a dramatic drop in the interest rate they are required to offer for their risky debt. Are junk bonds any less risky than when you could get an interest rate well over 10 percent? If anything, I think one could argue that there is more systemic risk in debt obligations than ever before. (Remember the relatively and historically safe mortgage market?)

However, our Federal Reserve’s supply side economic policy practice has succeeded in forcing investors to chase yield–accept increased risk while receiving substantially less return. For the first time in history, junk bonds are yielding less than 5 percent. Just a few years ago you could get a 5 percent return on 10-year treasuries, and just a few years ago junk bonds needed interest rates of over 20 percent to attract investors.

There will be a point when investors get burned by chasing yield (and risk). The Fed will be the one to thank for the market distortions that will ultimately “relieve” investors of hundreds of billions — if not trillions — of dollars. Our current market is no longer about risk and duration; instead it has been replaced with an excessive supply of newly created money trying to find some place to park itself.

This graph is just one more incredible sign of the distortions that have been created in our financial markets… but who cares because today the equity markets set a new record and Bernanke has been proclaimed THE HERO! He has managed to get the investment world to declare, “Forget risk; just give me yield!” At some point we will be reminded that risk actually means something. But don’t be surprised to hear something like, “No one could have seen this coming.”

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