Junk bonds: The penicillin for Fed tapering rumors
In the search for yield, investors take on more risk
Market uncertainty about the onset of the Fed’s plan to taper its mortgage-backed securities buying spree is apparently pushing investors over the edge, or at least giving them enough chill to search for a new penicillin to ease their ache for attractive yield.
So what’s the cure to this phenomenon? One might hope for a clear statement from the Fed on what exactly is next. But it’s a well-known fact that Bernanke and crew will tease and taunt the markets, without giving an exact end-date for QE3.
We know it’s going to end, but for now, the date of the grand finale is nothing but a giant guessing game. And the markets don’t like guessing games.
Just take a look at the blood bath in the HW 30 stock index Monday. The index – a compilation of stocks that drive the U.S. housing economy – took a beating in the wake of ongoing uncertainty about how long Fed intervention will continue. With the FOMC meeting minutes due out this week, the markets are a bit eager, not to mention shaky.
The HW 30 index declined nearly 2% by close of trading Monday.
It also doesn't help that real estate investment trusts took a beating Monday — see American Capital Agency Corp. (AGNC); Armour (ARR); Apollo (AMTG); Ellington (EARN); Answorth (ANH); Western Asset Mortgage Capital (WMC); Dynex (DX) and Newscastle (NCT).
So what’s an investor to do?
The simple answer: search for enough risk to obtain yield, suggests James Frischling, president and co-founder of NewOak Capital.
Frischling sees investors pounding for a chance to get into lower-rated loans, which have been fueled by the return of the collateralized loan obligations market.
"The demand for higher returns and lower rated fixed-income assets has soared since Fed Chairman Bernanke made it clear that the tapering of its monetary stimulus program would commence before the end of the year," said Frischling.
"Fear of rising rates has resulted in a selloff in the highest rated and safest securities, while junk bonds and loans have seen modest gains. Investors are willing to add credit risk to their portfolios in order to pick-up the additional spread associated with these riskier assets and shorten duration," he added.
Sarah Hu with Royal Bank of Scotland (RBS) is also noticing a response to the uncertainty, but she doesn’t know how long it will last. Right now, when comparing jumbo loan rates to conventional rates, investors may be finding it more attractive to latch onto jumbos, given the high credit quality of many of those borrowers, Hu told HousingWire.
"We think larger loans should have a higher-risk premium, but that is not how the market is priced right now," Hu says.
When looking at the jumbo market versus conventional, investors are seeing two different factors at play, adds Hu, with jumbos you have better credit borrowers and attractive fees relative to the conforming market, so the spread looks attractive.
The takeaway: the search for your yield is a desperate fight with uncertainty fueling the marketplace, but investors are going to search high and low for it.
"In addition to the search of yield in the face of the Fed’s tapering, the demand of these lower rated loans has also been fueled by the strong return of the Collateralized Loan Obligations (CLO) market," Frischling explained. "While structured finance took a beating as a result of the financial crisis, the CLO market weathered the storm better than their ABS CDOs cohorts."
Either way, the market is getting a bit tricky, but the end goal is clear: investors will keep pushing for the best yield and taking the most reasonable chances given the limited information they have right now.