Is It Time To Start Taking Profits In Junk Bonds?

The Federal Reserve is expected to raise interest rates again later this month, but if that’s another signal that headwinds are building for fixed-income securities the warning isn’t resonating in the junk bond market these days.

The crowd’s appetite for below-investment-grade US debt remains strong in the eighth year of a US economic expansion. By some accounts, the hour is late and so there’s reason to wonder if a full-throttle embrace of junk is wise. With yield spreads near post-recession lows and the expected trajectory of interest rates still pointing upward, the bears argue that low-grade corporate debt’s best days are in the rear-view mirror.

Yet the sentiment reflected in prices presents a different view, based on several widely held funds targeting US high-yield bonds. SPDR Bloomberg Barclays High Yield Bond (JNK), for example, closed yesterday near its all-time high. Ditto for iShares iBoxx $ High Yield Corp Bond (HYG) and Vanguard High-Yield Corporate Investment (VWEHX), which celebrates its 40th birthday in December.

Despite the long-running bull market in junk, trailing returns remain moderate. VWEHX, for instance, delivered an annualized 5.2% total return over the past five years through yesterday’s close (Sep. 11). That’s roughly double the return for iShares Core US Aggregate Bond (AGG), which tracks a popular benchmark that’s widely used as a broad investment-grade bogey for US bonds.

From a valuation perspective, however, the argument for caution isn’t easily dismissed. The ICE BofAML US High Yield Master II Option-Adjusted Spread has fallen to 3.4 percentage points – close to the lowest premium over a comparable Treasury yield since the recession ended in mid-2009.

One researcher last week opined that the US high-yield market has become a refuge of sorts for investors looking for an alternative to stormy weather in some corners of global markets — think emerging markets, for instance.