The Bubble That's Refusing to Die

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They're back! According to the Financial Times, bubble-era financing practices that were buried with the crisis have risen from the grave in recent weeks. This resuscitation is more confirmation that the Fed's zero interest rate policy is (once again) stoking a bubble in risky assets. In this case, it's in corporate bonds, but pay attention, share investors, as a similar phenomenon is at work in equity markets, too.

The "zombie" practices that could well end up devouring investor wealth again are:

  • Covenant-light bonds, which place very few restrictions on borrowers.
  • Pay-in-kind toggle notes. These notes are debt that can be repaid with -- wait for the punchline -- more debt issued by the borrower.
  • Dividend recapitalizations. An LBO-boom favorite wherein companies owned by LBO firms issue debt specifically to pay their owners a special dividend.

We can expect the usual suspects -- Morgan Stanley (NYSE: MS  ) , Goldman Sachs (NYSE: GS  ) , and Bank of America Merrill Lynch (a unit of Bank of America (NYSE: BAC  ) ) -- to participate in this nonsense, along with private equity firms such as the Blackstone Group (NYSE: BX  ) . But there is another, bigger culprit at work here.

Avoiding a repeat of the last fiasco
In the minutes of its November 3-4 meeting, the Fed's Federal Open Market Committee noted "the possibility that some negative side effects might result from the maintenance of very low short-term interest rates for an extended period including the possibility... [of] excessive risk-taking." So, there's a possibility of a possibility? Surely, we've strayed beyond that realm into that of "likelihood," or even "near certainty." As such, it is becoming more urgent every day that the Fed stir itself and raise interest rates to avoid a repeat of the atrocious mismanagement of the Internet bubble aftermath, which produced the run-up in home prices and the credit binge.

Stocks are vulnerable to an "early" rate hike
Athough a rate hike would be the best course of action, it would hardly be painless, since equity and bond markets have rallied hard on the conviction -- promoted by the Fed -- that there can be no rate rise until the second half of 2010, at the earliest. Weak financials such as AIG (NYSE: AIG  ) , Citigroup (NYSE: C  ) , or Fannie Mae (NYSE: FNM  ) would certainly be vulnerable to a surprise rate hike, but they aren't alone; after all, the broad stock market is noticeably overvalued.

The Federal Reserve's current policies are creating tangible new risks for investors. Global Gains co-advisor Tim Hanson explains why you need to get out now!

If you're concerned about the threat of inflation, focus on companies with sustainable dividend growth. The team at Motley Fool Income Investor can show you how to build -- and manage -- a portfolio of high-quality company stocks with robust dividend yield. To find out their six Buy First stocks, take advantage of a 30-day free trial today.

Alex Dumortier, CFA, has no beneficial interest in any of the companies mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. Motley Fool has a disclosure policy.

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