Bond Market: Is there a bubble lurking?

Everyone these days hear about Double dip recession, Euro dollar crisis, Greek debt crisis, Irish instability, Poland debt  and now bond bubble. Lets understand some basis on Bond and why some economists and investors think that we may see similar trends as we saw in the housing bubble..

Availability of easy resources with no constraints on the borrowers coupled with greed on the part of investing companies to package the same debt into exotic and yet risky products and funnel it across up & down the financial industry chain and not realizing the simple truth that if section of the majority of borrowers were to default the cascading impact could swallow global companies like Lehman & Brothers, AIG, Bear Stearns into bankruptcy are yet again seeing the potential seeds being sown for the history in making.

Bond & How it works:
Countries, Corporations, Charities, Cities, Counties all need resources to fund their operations and to beef up the resources they could either take loans from Financial Institutions or issue bonds (its just a loan with contractual terms) in return for an interest to be paid for the term of loan period plus principal in layman terms. But the packaging of contractual terms and features coupled with market conditions and risks can make bonds very complicated.

The contract terms relates to Interest rate (aka Coupon rate), Maturity, Callability, Convertibility, Secured, Principal and are traded just like Equities either for discount or premium depending upon the quality of the Issuer and risk associated with this loan. All bonds quality, risk and returns are rated by major agencies like Moody, Standard & Poor and Fitch based on issuer's background and contract terms to enable customer to pick Bonds that suit his/her preference on risk & rewards. So in general higher the risk, higher is the yield an investor seeks for a given set of contractual terms. Note these ratings change over the life of the bond and that makes it complicated in a dynamic free market. The market pricing of the bond has an inverse relationship to interest rates.

These are also named as debt, fixed income or credit in the financial institutions.The size of the global bond market as of 2009 is estimated at $91 trillions and US leads the bond market with $32 trillions followed by Japan. Majority of the $899 billions of the daily trading volume happens between broker dealers and large institutions.

Individuals can invest in bond funds and an array of indices are available for managing the portfolio and measuring performance like Barclays Aggregate, Citigroup BIG and Merrill Lynch Domestic Master.

Junk Bonds:
These are high risk, low rated debt with a promise of high yields issued by corporations to entice the public to subscribe to their bonds with no guarantees. This type of bond is subject matter for this discussion.

With Interest rates being very low for a good period of time, investors are still not bracing the equity market for the fear of double dip recession but however are seeking steady returns by investing in these high yield junk bonds while ignoring early warnings reminiscent of credit bubble mainly credit worthiness.

In the last nine months, companies have already sold $172 billion in junk bonds as per Dealogic a data provider. Factors for this scenario appears to be,  the declining rate of corporate defaults, corporations in general have a good balance sheet. Also, Interest rate in near future does not seem to rise based on assumption that Fed would unleash with a tidal wave of freshly printed US-dollars to avoid double dip recession and alleviate US Job market. This act by Fed is already put in full play by major countries like China, Japan, Russia & South Korea who have already printed additional their respective sovereign paper currencies in the market to make sure their currencies are not overvalued that would have negative impact on their exports.

More and more Corporation are seeking this route both with strong and not so strong ratings on their bonds. Companies with weak credit ratings are paying just 6.2% points above Treasury's down from 20% points in 2008.  Companies with fewer protection covenants, provisions in their bonds but with high yield are gobbled up by the investors and this echoes similar symptoms we saw at the start of housing bubble where Financial Institutions were more than willing to provide loans even when Customer credit rating was not favourable or downright unworthy.

Investors with their appetite to find niche markets to plough and park their funds for returns hopefully have not yet forgotten the recent fresh memories of the credit bubble which are still lingering for majority of them.