Is a bubble growing in junk bonds?

(MoneyWatch) The low interest rate environment we're in has driven investors to buy riskier assets in their search for higher yields. Now, this rapid flow of money may be creating a bubble in the high-yield bond market.

Investors poured more than $72 billion into high-yield bond funds last year. The extra yield investors demand to hold the securities rather than Treasuries has fallen to less than 5 percent from the record high of 21.8 percent in December 2008.

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There has been such a flood of money into high-yield debt (including floating rate notes sold by banks) that some members of the Federal Reserve have issued warnings. Recently, Fed Governor Jeremy Stein warned that some credit markets, such as corporate debt, are showing signs of potentially excessive risk-taking. And Esther George, president of the Federal Reserve Bank of Kansas City, voted against continuing asset purchases at the central bank's January meeting out of concern about "the risks of future economic and financial imbalances."

Not only has the yield spread narrowed, but the credit quality of the loans has deteriorated, increasing the risk of default. And that's a sign of a bubble brewing. Keep in mind that while the yields on the mortgages that caused the 2008 financial crisis seemed attractive, credit quality had deteriorated. In its February 12 report, Moody's noted that the covenant quality of North American high-yield bonds has continued to slide. Covenants are the agreements between a bond issuer and the bond holder. They're designed to protect the interests of the bond holder. For example, they might include restrictions on the issuer's ability to take on additional debt.

And as sure as the sun rises in the East, Wall Street is taking advantage of the trend, selling almost $9 billion of collateralized loan obligations (CLOs) in January, the busiest month of issuance since November 2007. CLOs are pools of high-risk loans that are sliced into securities of varying risk and return. Sound familiar?

The bottom line is that in their quest for yield, investors are getting less and less compensation for taking on more and more risk. Investment memories can be very short.

Here's another problem for investors in high-yield debt: The risks are asymmetric. Over half of the almost $1 trillion in high-yield debt outstanding is trading above the price at which issuers can call in the bonds. That means bond prices will fall if rates rise, but won't rise much (if at all) if rates fall.

The long-term evidence is that credit risk has been the most poorly rewarded risk premium (compared to the risk premiums for stocks, small stocks, values stocks and term). While high-yield bonds often carry yields hundreds or even thousands of basis points higher than that of Treasuries, the excess realized returns have been minimal, certainly not justifying the risks. In other words, because of the risks of default and calls, investors have earned only a small fraction of the excess yield.

Making matters worse is that the risks of high-yield don't mix well with the risks of stocks, making them an inefficient choice from a portfolio perspective -- the only right way to analyze an investment. The reason is that their risks tend to show up at the same time the risks of stocks show up.

The year 2008, when the S&P 500 Index lost 37 percent, exemplifies this pattern. While the Vanguard High-Yield Corporate Bond Fund (VWEHX) lost 21.3 percent, the Vanguard Intermediate-Term Treasury Fund (VFITX) gained 13.3 percent. And lower-rated junk bonds performed much worse. Just when you needed the bond portion of the portfolio to help reduce the portfolio's risk, high-yield bonds fell sharply -- while high-quality bonds rose in value.

This example demonstrates that the oft-cited diversification benefit of high-yield debt disappears when it's needed most. And that creates another problem that is often overlooked. When stocks fall sharply, you need to rebalance your portfolio, restoring the stock allocation to its desired level. If you owned Treasury or other high-quality bonds that appreciated during this period, you get to sell them at higher prices to buy stocks at their now lower prices. On the other hand, if you owned high-yield debt, you were forced to sell them at lower prices to buy more stocks.

This long-term historical evidence is why I don't recommend you don't include high-yield debt in your portfolio. And while high-yield debt has performed well for the past few years, there are now signs that the trade appears to be getting "crowded."

Image courtesy of Flickr user Stellajo1976