No, the Fed can’t save the junk bond market, Goldman cautions

Over $6 billion has poured into the two biggest below-investment-grade bond funds since the Fed said it would start buying

Junk bonds can be risky


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Exchange-traded funds offering exposure to junk bonds may lack the full Federal Reserve safety-net that investors are betting on, warn analysts at Goldman Sachs.

The central bank announced in early April that it would buy ETFs that contained bonds with speculative, or “junk,” ratings in an effort to keep credit flowing through financial markets. An update Monday indicated that Fed purchases could start any day.

Investors responded to the historic move by pouring into the biggest junk bond ETFs, SPDR Bloomberg Barclays High Yield Bond ETF
JNK,
+0.83%

and iShares iBoxx $ High Yield Corporate Bond ETF
HYG,
+0.88%
,
hoping to get ahead of the Fed’s purchases. From April 9, the day of the Fed’s announcement, through May 4, JNK took in $1.6 billion, while HYG has seen inflows of $4.71 billion, according to Refinitiv.

But a bigger tsunami of downgrades may lie ahead, Goldman cautions, and those risky bonds most likely to get marked down make up an outsize segment of those funds.

See:Wave of corporate defaults could reach more than 20%, despite Fed’s foray into buying junk bonds, warn analysts

So far in the second quarter, downgrades of bonds rated “BB,” the highest rating on the below-investment-grade spectrum, has matched the number of downgrades in the first quarter, which was already an “elevated” level, Goldman analysts wrote. And ratings agencies have signaled more downgrades may lie ahead, through the use of “Negative Outlook” or “Negative Watch” designations.

Related: The Fed is going to buy ETFs. What does that mean?

BB-rated bonds make up half of the portfolios of both JNK and HYG, Goldman notes.

In a separate report, State Street Global Advisors’ Michael Arone mused on the market distortions created by the Fed’s decision to buy assets it previously would have considered untouchable.

“With 10-year US Treasuries yielding a miserly 0.6% as of April 28, income-starved investors such as pensioners, retirees and savers don’t have many low-risk options to generate much needed income in their portfolios.”

The 10-year Treasury note
TMUBMUSD10Y,
0.644%

yielded
TMUBMUSD10Y,
0.644%

0.64% Tuesday afternoon, according to FactSet data.

However, the Fed support for junk debt may be creating an implicit floor for speculative investors and yield-starved buyers alike.

“Formally risky bonds suddenly appear to be less risky,” Arone said. “Strangely, this is occurring while the economy is entering recession, corporate profits are plummeting and job losses are skyrocketing. The disconnect between the underlying fundamentals of bond issuers and bond prices is tough to reconcile,” he wrote.

Read:Junk bonds: the on-again, off-again love affair cools again for ETF investors

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