The Fed starts monetary tightening: What’s next for junk bonds?

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Key implications of the Fed’s QE3 exit for junk bonds and leveraged loans

The Fed’s policy statement at the end of its October Federal Open Market Committee (or FOMC) last week stressed the improving economy. In a first, it also mentioned that measures of labor market slack had reduced. The risk of inflation falling persistently below its 2% target had also reduced somewhat.

Part 8.1

Rate hikes aren’t due for a “considerable time”

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The Fed also allayed some fears on the rate hike issue. Although the timing and path of the federal funds rate were data-dependent, the Fed anticipated that the rate increase wouldn’t come until a “considerable time” had elapsed after asset purchases ended. As we explained in Part 1 of this series, the Fed announced its exit from its monthly bond purchase program. The language of the Fed’s statement implies that rate hikes won’t be immediatel.

Read more about the FOMC in October’s FOMC meeting marks the end of the Fed’s asset purchases.

Impact of QE3 on financial markets

The exit from QE3 also implies lower market liquidity. This is likely to adversely affect financial markets and stock (IWM)(SPY) and bond prices, all else being equal. Stock and bond prices appreciated significantly since the inception of the Fed’s monetary stimulus in December 2008. This appreciation is partly due to the lower yield environment brought about by monetary easing. An improving economy has also benefited stocks and junk bond returns.

An improving economy, coupled with a higher federal funds rate, would also put upward pressure on inflation and yields in 2015. This would benefit leveraged loans (BKLN) and floating-rate (FLOT) debt while affecting returns on fixed-rated debt (BND).

Impact on high yield debt

While credit spreads may narrow further for high-yield bonds (JNK)(HYG) due to an improving economy, the increase in yields due to the removal of monetary stimulus may negate any positives from the decline in spreads. Basically, yields on junk bonds may go nowhere or even increase once the rate hikes commence. Analyst widelys expect this to occur in 2015. This would limit any upside in junk bonds going forward. As we mentioned earlier, leveraged loans and floating-rate investors may benefit from this trend.

For more important bond market updates, visit Market Realist’s Fixed Income page.

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