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Has 'Moral Hazard' Been Fueling the Corporate Bond Market?

Record issuance and more defaults may warrant a rethink of high-yield exposure.

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"Moral hazard" involves someone taking an action that will benefit them if it succeeds, while knowing they won't have to bear the consequences if it doesn't. The term is typically used to describe an economic risk, but in a simpler form it is ultimately about the power of incentives. For example, someone who rents skis rather than owning them would be less inclined to treat them with precious care, especially if the rental includes insurance. They might not hesitate to cruise over rocks and tree branches on the slopes, for example, and might toss rather than carefully place the skis into the back of a truck. That's easy to envision if they never see the skis at the end of a vacation and the rental shop has to deal with the damage. You're more inclined to take on risk--particularly if cruising over rocks and branches is more fun--if you're insured against the potential consequences.

The concept has again come to the fore in 2020 as the Federal Reserve has backstopped credit markets in response to the coronavirus. The Fed’s actions have benefited many, but they have arguably created artificially high prices--affecting the risk/reward trade-off for investors in the high-yield bond market. The Fed essentially made it safe for buyers to get the benefits of owning junk bonds, while knowing that the prices of those debts will likely be kept from falling too far given the Fed's support.

Garrett Heine does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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