High yield bonds have recently hit a milestone going below 6% which should be a cause of concern for investors as the flight to yield could be taking on too much risk for the costs. There are a lot of pundits saying this but the truth is a catalyst will have to occur for this asset class to become cold. The virtuous circle that is created in high yield bonds, of low interest rates causing lower than expected rate of defaults, will keep the asset class attractive to investors looking for better than average returns. However one threat to this rally, and the catalyst that I feel will take hold over time, is the increasing rates of treasuries.
Higher interest rates on treasuries will eventually cause pressure on corporate and eventually high yield bonds, as safer alternatives become a better alternative for a relatively small reduction of yield. I look at this as a demand driven drop in prices. The chart shows how the rally on treasury yields has dampened the price rally in corporate bonds. This has not occurred in the high yield space but could occur if the pressure on credit spreads continues. This will create a vicious circle over time, where higher rates will see bad companies that have been surviving off of low borrowing rates and high demand for yields start to default.
It seems that the market is experiencing another gap in the reality of the situation and the actual events that have occurred. While a deal has in fact been made it was partial and not necessarily resolving the many issues that have been plaguing the decision making of businesses. More numbers will have to come out showing that the rest of the economy is not feeling as good about the prospects as investors are right now. Perhaps this is just the beginning of year buying or part of a larger trend in optimism, but one cannot ignore the severity of the rally over the past few days and start to think about the sustainability of it. The only real loser in this market is bonds, with the EDV being down 4.6% in the past two trading days one has to question if there is portfolio realignment going on or purely a chase to risk with some uncertainty (at least for now) being out of the market.