It's Time To Cash Out Of The Junk-Bond Rally

With almost no fanfare, high-yield bonds (also known as junk bonds) hit a major milestone this week.

The average junk bond saw its after-market yield dip below 5%. That's down from 5.67% at the start of the year, and just a tick above the all-time low of 4.96%, set in 2013. A deep look at why these yields are plunging suggests you'd be wise to book profits in such bonds right now, as the factors that are driving them may not last much longer.

To be sure, virtually every type of bond is in rally mode. Spanish bonds, for example, which still carry a considerable amount of economic risk, have seen their yields fall from 7.5% two years ago to a recent 3.6%.

Similar bond rallies are taking place all across the globe. David Woo, who follows the global bond market, suspects China may have a hand in all this. That country's move to rein in the issuance of credit has led excess Chinese capital to rotate into U.S. government bonds. And that bond buying has led to liquidity pouring into many other types of bonds.

Bonds typically rally when economic conditions weaken, but Woo notes that a range of economic measures -- especially regarding the U.S. economy -- have looked a lot perkier lately.

"Why have Treasury yields become seemingly insensitive to improving data and (Federal Reserve) tapering?" Woo wondered in an April report. He looked at a series of factors impacting bonds of various durations, and concludes that "it is as though while the market is becoming more optimistic about the short-term growth prospects of the U.S. economy, it is getting more pessimistic about its longer-term outlook."

Yet Woo doesn't think that this is a satisfactory explanation. Instead, he cites the Chinese buying of U.S. bonds as the key factor here. "What worries us is the possibility that Chinese purchases have masked the impact of Fed tapering. This suggests that volatility is too low." Said another way, in the absence of Chinese bond buying, U.S. interest rates would now likely be moving higher, not lower.

Let's pivot back to Woo's comment that the bond market is seemingly "getting more pessimistic about its longer-term outlook." The bond market may be more adept at pricing in longer-term structural challenges than the stock market can, but it sure does look like the U.S. economy is building a head of steam. Michael Hartnett, chief investment strategist at Merrill Lynch, is "convinced that U.S. growth will accelerate in coming quarters. Our economists forecast 3% to 3.5% for the next three quarters, the most sustained period of 3%-plus growth since 2005."

Hartnett's explanation for the robust bond rally: "ZIRP mania," short for "zero interest rate policy." That's his term for carry trades where investors borrow short-term funds that charge minuscule interest rates and reinvest them into higher-yielding bonds, such as junk bonds. His conclusion: "When the end of zero rates is threatened, likely this autumn as unemployment rates drop to uncomfortably low levels, both credit and stock markets should correct sharply."

The Takeaways For Junk Bonds

The various moving parts of the global economy, from China's bond buying to zero-interest-rate carry trades to a very low degree of volatility, have led to a stunning five-year rally for junk bonds. The SPDR Barclays High Yield Bond ETF (NYSE: JNK ) , for example, has nearly doubled in value over the past five years.

The average bond on that fund is priced at $106.29, which has pushed the 30-day SEC yield down to 4.71%. Yet an improving economy, which could push the risk-free 10-year Treasury notes past the 3% mark and toward the 4% mark over the next year, will likely make junk-bond yields seem too small to justify owning them. Michael Hong, a bond fund manager at Wellington Management Co., recently told The Wall Street Journal that rising junk bond prices and slumping junk bond yields means that "there's a real possibility of significant price depreciation."

Make no mistake, a generally healthy economy means that junk-bond default rates remain quite low: Around 2% of them defaulted in the first five months of 2014, according to Moody's, well below the 4.5% average going back to 1993. The bond-rating firm does expect default rates to start to rise -- to 2.4% in 2015 -- which is still relatively low, but would represent a trend reversal from this typically risky asset that has recently been seen to be fairly "risk-free."

Risks to Consider: As an upside risk, there is so much global liquidity sloshing around that all assets -- including junk bonds -- could see further asset inflows before the broader backdrop alters.

Action to Take --> There are a whole host of factors leading to the current rally in junk bonds. Yet this perfect backdrop is bound to wither away, especially if rates on the 10-year Treasury note start to rise in the face of a continued strengthening in the U.S. employment picture.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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