Fed's Warning on Junk Bond Bubble Matters More Than You Think

NEW YORK (TheStreet) -- When a Federal Reserve governor other than Chairman Ben Bernanke gives a speech, the temptation to take a nap is powerful, but Thursday's warning from Jeremy Stein about a junk bond bubble matters more than many investors are likely to realize.

Speaking in St. Louis Thursday, Stein voiced concern about "a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit."

Stein isn't the first smart person to worry about a junk bond bubble in recent weeks. Investor Wilbur Ross and turnaround adviser Jim Millstein voiced similar concerns in a panel discussion hosted by Bloomberg last month.

The difference is that Stein, as a member of the Federal Open Markets Committee, has a vote on whether the Fed should try and pop that bubble, which it has had an important hand in creating by building up an unprecedented $3 trillion bond portfolio.

Investors are expecting the Fed to keep adding to that portfolio -- potentially inflating the bubble -- for another six months to a year. Any hint that the Fed may hit the brakes sooner than that could cause a sharp rise in bond yields, in anticipation that the central bank may eventually begin selling bonds. Too sharp a rise could bring lending to a halt and throw the economy back into a recession.

Despite the worrisome patterns observed by Stein, he added that "it need not follow that this risk-taking has ominous systemic implications."

Then again, what choice did he have? If he had said it clearly has ominous systemic implications, his speech would have gotten far more attention than he wanted. If the Fed sees a bubble forming, it wants to let the air out as slowly as possible. Thursday's speech by Stein was an attempt to do just that.

-- Written by Dan Freed in New York