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The Junk Bond Time Bomb

At some point, Wall Street will dry out, the New York Stock Exchange will return to life, and the traders will roll back into Lower Manhattan. And by most accounts, they will continue their trend of purchasing garbage.

Junk bonds are living up to their name again.

Companies with junk credit ratings have been increasingly issuing bonds for riskier purposes that could hinder their ability to pay back bondholders.

Demand for junk bonds has touched record levels this year as investors reach for their rich yields, a stark contrast to the meager returns available on Treasury securities and money market accounts. But the voracious demand has allowed companies to easily raise money for things that may actually end up weakening them.

So let’s set the scene. The financial crisis was caused by outsized risk and a frenzy for buying these risky financial products. After a few years of calm, now investors… are purchasing risky financial products in a frenzy. They may be DIFFERENT financial products, but it’s not like junk bonds have never gotten investors on Wall Street into trouble – Michael Milken, anyone?

This has been deteriorating over the last couple weeks. The quality of the bonds being traded have trended downward. Companies are using the influx of cash to engage in mergers and buyouts and paying off private equity owners, things that don’t improve the core business. So the businesses get riskier along with the investments. You can see exactly what’s happening by the fact that the more established institutional investors are starting to shy away from junk bonds. But that’s been more than made up by investors at the lower tier, who are basically buying up anything offered.

QE3 is being blamed as the culprit, forcing more risk into the system. I would chalk it up to a lack of long-term memory. There are plenty of areas to invest that beat junk bonds.

So when this all shakes out, and the investors and mutual funds come crying for a bailout, let this serve as a digital “I told you so.”

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David Dayen

David Dayen