There is debate raging on whether the Fed's asset purchases are creating another financial bubble. Some fund managers, like PIMCO's Gross has been quoted in the press suggesting there is "irrational exuberance" and that prices are irrational in the corporate credit and high yield (junk) bond market.
Prices are irrational, he says. They are characterized by tight spreads, record profit-margins (with plenty of room to fall) and a still fragile economy. Fed Chairman Bernanke argued against such views in his recent testimony before Congress. However, there is some dissension in the ranks and not just the perennial dissenters among the regional presidents.
Governor Stein has suggested the increase sharp increase in payment-in-kind bonds, where the interest is paid with new bonds, and covenant-light bonds, which have few safeguards for the lender, is suggestive of a frothy market.
The Great Graphic (above) from the Economist (who got it from Citigroup) shows that as the Federal Reserve buys Treasuries, retail investors are buying government and high yield corporate bonds as yields fall. And as yields fall, the spread between corporate bonds and Treasuries narrow.
The other Great Graphic comes from Barry Ritholtz blog, The Big Picture, which he got from the Wall Street Journal. It complicates the picture by showing a surge in demand for a float-rate notes. Unlike conventional bonds, whose yield is fixed from the time one purchases it, the yield of floating rate notes adjusts over time. The US Treasury is considering issuing floating rate note as well.
Previously, when investors may have been deterred from buying fixed income due to inflation, the US Treasury (and others) sold inflation-linked instruments. They were absorb the (measured) inflation risk.
Now investors may be worried about what happens when the Fed stops buying long-term securities (which we anticipate to take place toward the end of this year). The fear is that interest rate rise sharply. Issuers of floating rate notes bear the risk of rising interest rates.
The supply and demand of floating rate notes has surged here at the start of 2013. Perhaps investors are not being as irrational as it may appear.