After the conclusion of its two-day meeting last Wednesday, the Fed failed to give market and rate watchers a clue as to what to expect next.
That’s because it removed any language that might indicate a date for the first interest rate hike. At this moment, rates could rise as early as June, but I don’t believe the Fed can afford to raise rates until at least October, and maybe not even until next year.
Regardless of when rates rise, the Fed has turned the first interest rate hike into an outright guessing game. This speculation and uncertainty will offer many opportunities to profit, but some investments may suffer from an initial market overreaction.
And a market overreaction is sure to come. Because the Fed is no longer giving guidance on when to expect an interest rate hike, the markets are almost guaranteed to overreact whenever the news is announced — even if it is sugarcoated with dovish comments.
The market overreaction is going to be simple: Stocks will sell off, bonds will sell off — reflecting higher Treasury yields — and the dollar will rally.
Just remember, these swings will be only temporary. I have mentioned many times before why the Fed is in a predicament and must keep rates low (such as too much debt, a strong dollar crushing the earnings of American companies, America’s too-fragile economic recovery).
But these swings will still likely happen. And when they do, they will be quick.
There’s one investment class that will feel the bulk of the pain: high-yield corporate bond exchange-traded funds (ETFs), aka junk bond funds.
Not Worth the Risk
Since the Fed introduced its zero-interest-rate policy, investors have poured money into nontraditional areas. This includes equities in the stock market, as well as high-yield bonds and other riskier investments, all in search of yield that can no longer be generated by the previously favored Treasury note.
While stocks offer capital gains, as well as a highly liquid market and increasing dividends, corporate bonds don’t carry the same benefits. Yet, they have been gobbled up as if they were risk-free income because of other opportunities to collect any sort of stable income.
The big concern is that investors are adding exposure to this junk-grade debt through ETFs. At first glance, this investment vehicle offers many attractions to individual investors. It’s a highly liquid way to benefit from the higher corporate bond yields versus Treasurys.
But looks may be deceiving.
The liquidity is present at the moment because so many investors are buying these bonds and ETFs. If this buying slows, or better yet, reverses as investors overreact to the Fed raising rates, it will cause these ETFs to sell their bond holdings regardless of price — which will result in drastically lower prices, negatively impacting overall returns even if you plan to hold the ETF for years to come.
Already in 2015, inflows into corporate debt are up more than 300% compared to last year — and ETFs have accounted for 45% of those inflows, compared to just 7% a year ago.
That’s a cause for concern.
Especially considering the new regulations imposed after the 2008 financial crisis, banks in the U.S. are now no longer encouraged to hold riskier debt such as high-yield bonds. Historically, banks have been able to step in during sell-offs to improve liquidity.
They won’t be there next time.
Protect Your Investment
High-yield corporate debt is even on the new bond king Jeff Gundlach’s radar for what will be the tipping point for the next financial crisis — and it makes a lot of sense.
Corporate bonds are one asset that benefit the most from the zero-interest-rate policy. Sure, we’ve seen money flow into equities, but corporate debt is a direct relation to government debt for those who are seeking higher yields.
When the Fed decides to raise rates, even if it is gradual, it will likely cause an overreaction in those high-yield corporate debt holdings. The mentality behind the move is that a normalized interest-rate policy will cause U.S. Treasurys to generate greater income. As a result, investors will flood out of high-yield corporate debt in favor of less risky investments.
At this point, it’s about who you trust.
The Fed is trapped in a position where the market is practically begging for an interest rate hike at long last to improve yields versus a situation where a rate hike could destroy America’s financial position completely. Given that the Fed has offered virtually no guidance on the size of an interest rate hike or when to expect one, any move by the Fed could spell trouble for junk bond ETFs.
For now, make sure you don’t have any exposure to these high-yield corporate ETFs either in your 401(k) or personal investment account.
Editor, Pure Income