Another Bubble?

I have the feeling that FED is trying to create the bond market bubble to re-inflate the market. They wish that bond market and government spending can temporarily take over the role of equity market and bank loans respectively. Meanwhile, FED will deal banks with carrot and stick: "easy money" through buying assets and discount window is the carrot; tightened regulations is the stick. With money flooding, banks can survive under the current accounting principles and the banking regulations. Yet, without viable projects and bright expectations, in addition to the competition from the government, banks are reluctant to lend money. Afterall, if government takes this role, why do banks bother to risk of their own money at a highly uncertain market? Such attitude will dampen the recovery speed.

Back to the topic: bond market bubble. Can it be the savior? I am afraid not. Bond market will only alienate the recovery, not enhance it.

Now lets assume that FED measures work and bond market is hotter than the equity market. With insufficient participants in the equity market, it is no longer efficient and delivers no clear estimation through stock prices.

The way bond works, from an investor point of view, is a bet on the company's survival, not development. Bond price comes from the discounted cash flow of the principal plus the coupons. The only "derivative value" of bond is the coupons. Since coupon's nominal value is fixed, it does not relate to company's performance. It can only tell you the company has the ability to repay the debt but reflect nothing on its potential.

The present value of the coupon is only the nominal value divided by the current cost of capital. At the normal "healthy inflation" period, the maximum present value of the coupon is only at par when the market is estimated as risk-free. The higher the risk, the higher is the discount rate and the lower is the coupon present value. While in free market, the cost of capital is "negotiated at the best knowledge"; the benchmark, FED target rate, is manipulated as a tool for controlling economy. During a economic downturn, the risk is high and hence the cost of capital is high. But in order to "stimulate" the economy, FED moves the target rate low, at the expenses of tax-payer. On the other hand, during the economic boom, the risk is low and hence the cost of capital is low. But in order to "cool down" the economy to prevent inflation, FED moves the target rate high, at the expenses of debt-payer. The resulting effect is that while the actual risk of bankrupcy of company is high, the coupon has a higher value due to a lower FED rate for stimulation, and vice versa. In other words, investors are paid a lower risk-adjusted rate of return during a riskier period, and a higher risk-adjusted rate of return during a safer period. If we alter the view to corporate, the worser the corporate and the riskier the period, the higher is the present value of their coupons, and vice versa. All in all, it encourages riskier companies to issue bonds at riskier period and investors to buy riskier bonds at riskier period. What would happen when one day those companies really bankrupt?