A caution light for high-yield bonds

Your parents probably taught you some basic life lessons. Look both ways before you cross the street. Cover your mouth when you cough. Don’t buy high-yield debt securities when the yield spread between them and Treasuries is too low.

Just as the stock market’s price-to-earnings ratio can be a warning sign, so can the yield spread on junk bonds. And right now, that sign is flashing red.

Junk bonds — or high-yield bonds, the Wall Street name for them when the public is listening — get those high yields because they are issued by companies with suspect credit ratings. The high yields you get are the reward for the possibility, however remote, that the issuer will default and you’ll have to stand in line with other creditors in bankruptcy court.

Just how much more you get from junk depends on the state of the economy and the nervousness of bond traders. At the peak of the 2008 credit crisis, when traders figured we’d all be reduced to hunting with sharpened sticks, junk yields were 22.3 percentage points above Treasuries. Junk typically trades at about 5.5 percentage points above Treasuries.

But we’re not living in normal times. Currently, junk bonds yield 3.75 percentage points more than comparable Treasuries, the lowest spread since September 2014, said John Lonski, chief economist for Moody’s Capital Markets Research Group. Tight spreads are not a good omen for the high-yield market. Yield spreads typically rise because junk prices fall. In the 12 months following September 2014, the average high-yield ETF fell 3.9%, including reinvested interest, according to Morningstar.

Why are junk prices so rich? In part, because investors are searching for yield the way Arctic explorers searched for the Northwest Passage, with similar results. The average money market fund yields 0.27%, according to iMoneyNet. The 10-year Treasury note yields 2.46%. At those levels, a 5.17% 12-month yield — currently sported by the largest junk ETF, iShares iBoxx $ High Yield Corporate Bond ETF (HYG) — looks pretty tempting, especially for the nation’s growing population of baby-boomer retirees. “As the population ages, more people need income,” said Brian Kloss, portfolio manager at Brandywine Global.

Furthermore, the junk-bond default rate is expected to fall from 5.8% now to 3.7% by year-end 2017, said Mr. Lonski. Even so, valuations are still rich: High-yield bonds typically pay 4.5 to 4.75 percentage points more than Treasuries when the outlook for defaults is similar, he said.

The stock market’s euphoria has also spread to the junk market. The Standard & Poor’s 500 stock index has rocketed to a 12% gain since the November 8 election, buoyed by hopes of decreased regulation and lower taxes. Junk bonds have gained as well. “The market is really pulling forward significant growth expectations based on what they think could happen,” Mr. Kloss said.

At the same time, stock volatility as measured by the CBOE’s VIX index, is remarkably low. Sometimes called the “fear index,” the VIX measures implied volatility in the market for Standard & Poor’s 500 options. The VIX averaged less than 12 the past two months. The last time it did so was in February 2007. You may recall that 2007 was not a particularly good year for the stock market.

The seemingly fearless VIX makes little sense, given how rapidly the stock market has risen, and how expensive stocks are. “That’s the warning — the high yield market is priced to perfection,” Mr. Lonski said. A sudden shock could cause both stocks and high-yield bonds to tumble.

And there’s always the prospect of higher interest rates, prompted by a Federal Reserve that seems to be itching to hike rates. “To be fair, high yield usually has a shorter duration than investment-grade corporate bonds,” Mr. Kloss said. Nevertheless, he has added some floating-rate bonds to his portfolio, and shifted some assets towards areas that might benefit if President Trump’s policies come into play.

Nevertheless, it’s probably a good idea to be somewhat cautious with investments in high-yield bonds for your clients. High valuations don’t necessarily mean a market tumble is imminent, but it doesn’t mean you should be overzealous, either. “We’re still constructive on credit, but we do believe in the business cycle,” Mr. Kloss said.