Let's start off with junk bonds.
First, what is a junk bond? "A colloquial term for a high-yield or non-investment grade bond. Junk bonds are fixed-income instruments that carry a rating of 'BB' or lower by Standard & Poor's, or 'Ba' or below by Moody's. Junk bonds are so called because of their higher default risk in relation to investment-grade bonds."-http://www.investopedia.com/terms/j/junkbond.asp
In addition; junk bonds are securities and are monitored by the SEC (Securities and Exchange Commission). Junk bonds are easily traded through large funds like hedge funds, and mutual funds. They are also relatively liquid (easily converted into cash). Investors who trade junk bonds can convert to cash typically within three days.
In laymens terms; a junk bond is a bond that offers a higher yield (interest) than traditional bonds. However, the higher yield also comes with an attached higher risk, that risk being the possibility of a default of the bond by the issuer (typically a large corporation). Credit rating agencies asses these companies and distinguish the credit-worthiness of companies who issue such bonds. Because the bonds have a higher degree of risk associated with them, investors demand higher yields than in safer bonds.
As I mentioned above junk bonds are traded by a lot of different folks including hedge funds, mutual funds, and Exchange Traded Funds (ETF's). What is an exchange Traded Fund? "A security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold."-http://www.investopedia.com/terms/e/etf.asp
Or more simple terms as Investopedia describes it: "Because it trades like a stock, an ETF does not have its net asset value (NAV) calculated every day like a mutual fund does.
By owning an ETF, you get the diversification of an index fund as well as the ability to sell short, buy on margin and purchase as little as one share. Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund. When buying and selling ETFs, you have to pay the same commission to your broker that you'd pay on any regular order.
One of the most widely known ETFs is called the Spider (SPDR), which tracks the S&P 500 index and trades under the symbol SPY."
In my own words: you get a little slice of variety. Rather than buying a single stock or bond, you can purchase an ETF that consists of dozens of different stocks, bonds, whatever.
Now what is a junk loan? Well, it's like a bond but it's not really a bond. It's classified as an asset rather than a security. Also important to note that junk loans cannot be quickly converted into cash so they are not very liquid. Instead, there is a long legal process behind the trading of junk loans that take as much as two to three weeks.
Junk loans are pegged to floating rate bench-marks, where as junk-bonds are not. Instead, junk bonds are fixed. Floating rates mean that the yield of the loan (or security, asset, etc) is not just 5% or 6% or any fixed, permanent number. Instead, the interest rate (yield) floats with the underlying interest rate set by the fed. If the fed raises interest rates and you are a loaner than you have just gained that higher bit of interest. If the fed lowers rates, the yield on that loan also decreases. Depending on your situation this could be good or bad. The bench-mark is a target number they (the loaners) set. It's like the fed when they set an inflationary target of 2% or 3.5%. They usually aren't aiming specifically for that number but rather a number close to it. Say, something like 1.85% or 3.0%. There are also inverse floaters where the yield of a specific security or asset moves inversely to the actual rate set by the fed.
The junk loan market currently sits at around $750 billion in the U.S. alone whereas the total size for junk bonds here is about $1.3 trillion. That said, there has been a rush by investors to get their hands on junk loans due to their higher yields in comparison to many securities, bonds, and other traditionally safer loans.
One of the main areas of concern between junk loans and junk bonds is how they're traded. With a junk bond you can trade it much like a stock because of it's relative liquidity. But with a junk loan, where a trade can take two to three weeks due to the legal process and paper-work behind it, they're not so easy--or fun! If you own an ETF as mentioned before then you own a share of many different stocks, bonds, or whatever. The share itself is not the actual stock or bond, it is a share, so a percentage of that stock, or bond that was issued by the company. So you may trade shares as quickly as you can trade stock but the actual junk loan is not traded at the same time the share is. Why? Because of the time it takes to process that loan and get it signed by attorneys, managers, and whomever else.
As Bloombergs Lisa Abramowicz explained recently it's a problem that is shared by mutual funds, and exchange traded funds. In her own words "you've got shares of mutual funds and exchange traded funds that trade like stocks and trade like securities and they are backed by assets that are much less liquid..." so what do fund managers do? "They hold more cash, they hold more bonds rather than loans to allow you to have something to sell more easily and they also get credit lines. They actually have facilities with banks where they can borrow if they need to, to meet redemption's while they wait to get their money back. The thing is, all those things cause a drag on their performance. So the investor is getting hurt by that drag."
Pretty interesting!
Junk bonds have become popular once again, as they were in the early 90's which led to a series of banking catastrophes. This is what leads us on to the new fed chairwoman, Janet Yellen who has yet to prove she has the gusto or fortitude to lead us out of the turmoil were in and clamp down on both banks and investors alike. She's continued QE though she announced an end-date for it which probably shouldn't have been mentioned specifically. All we needed was a general time-frame not the immediate date for the pullout as banks will now prepare themselves in such a way that will prove to disappoint those of us who have to deal with them. Sort of like when the Obama administration just recently announced the exact time when we would pull out our remaining forces from Afghanistan (to be taken lightly, we will still have hundreds of operatives over there).
So what is the fuss with Janet Yellen?
First, it's the low interest rates. She's adamant about keeping them hovering around 0%. This act encourages risky behavior by investors and banks alike as investors seek the highest possible return and banks being banks are always more than eager to find ways to provide investors with those possible yields. Part of the risky behavior that investors are now participating in is with junk loans and junk bonds. Yes, that same junk I mentioned above. That's what's fueling the bubble in junk right now! I say bubble because as soon as the fed raises interest rates, investors will pull out of such risky investments and pour their hard-earned cash into more traditional and safer investments. But that's also not the only reason junk is believed to be in bubbles at the moment. The rise in interest would also affect the amount the debt these companies have taken on, so their liabilities will increase slightly to significantly depending on the amount of the rise in interest rates by the fed.
This goes on further if we were to examine the leverage of the top companies and funds in the U.S. Just going back on junk loans and bonds again, we remember that while bonds are fairly liquid, loans are not. So that would mean $750 billion invested in junk loans could quickly turn into something like a run as investors rush to pull out and cash in on what they have left as a result of rising interest rates and rising speculation about the future of junk loans. Worst case scenario: the pull out of investors in the junk loan market could also see small sell-offs in other categories of financial products like asset-backed-securities (ABS) as investors look to cover any small losses in the junk-loan market, fearing a quick-sell within their own investments by other twitchy investors.
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