Jim Armitage: So should we be in a real funk as investors rush into buying junk?

Global Outlook

Last week I reported how the exotic financial products that blew up the world in 2007 are back with a vengeance. If that wasn't enough to get you stocking up on tinned food and a new bunker in the garden, perhaps a story buried in yesterday's Financial Times might be.

It was all about the return of investors to the junk bond market. There's nothing wrong with junk bonds per se: despite the dodgy name (salesmen prefer the term "high yield"), they are simply loans to companies that have a higher risk than usual of being unable to pay you back. In return for that high risk, they command a higher return for investors.

With interest rates at record lows everywhere else, retail investors are flooding back into junk bonds like billyo. Banks are delighted at this fact, saying that it shows how confidence is surging back into the economy due to better news on jobs and other measures. Perhaps this is right, but is this really a market that retail investors should be backing? They're called junk bonds for a reason, because they can easily turn out to be just that: worthless rubbish.

The general public have pumped some $306m (£203m) into this stuff so far this year – and it's only March.

A banking analyst told me yesterday that this was all fine and nothing to worry about: bonds are fairly easy to understand, after all. People know the risks. But I'm not so sure how well many of these new investors are having the risk explained to them by their advisers. Do they know, for example, that the biggest bond investors in the world, like Bill Gross's Pimco and BlackRock, are warning of a potential junk bond slump around the corner?

It's a general rule of thumb in investing that by the time the poor old retail punter sniffs out a good deal it's time to sell. I'd suggest that time has probably arrived. There will be a lot of scorched fingers by Christmas.

That's bad for those likely to get burnt. But at least any damage would be limited to them, you may say. Possibly. Possibly not.

The problem is that company debt has traditionally been the preserve of medium- to long-term investors – pension funds and insurance companies who hold on to investments until they reach maturity. This is healthy as it creates stability for the borrower and some level of certainty for the funds.

But with the rush of retail money into junk bonds, through mutual or exchange traded funds, you get the high likelihood of extreme volatility, as punters pile in and out at will. So what happens to the medium- or long- term loan for a company when all that retail money runs out of the door? You get a funding gap – the money behind the loan is simply not there. Through absolutely no fault whatsoever of the company borrowing the money.

Clearly, we're not yet in that situation – quite the opposite. But if the money that's flowing in does suddenly retreat, real businesses using the bond market for their debt could be in a lot of trouble.

Gillian Tett, the FT's sage who spotted the last crisis coming, says she doesn't think that's going to happen. Phew. But we really don't know that. In fact, due to the complexity of the way this high yield debt is traded, nobody really even knows how big those potential funding gaps would be if the worst happened.

Not exactly reassuring, is it?

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