Is the Junk Bond Bubble Deflating?

We have seen several months of market fluctuations which have sent  junk bond yields soaring higher as prices fell off sharply. The air is now being let out of this balloon.

The bubble is finally losing air. The spread between U.S. Treasuries and BBB- rated bonds, these are the bonds with maturities of 7-10 years, is moving back closer to it average we saw 20 years ago. This could not be said for bonds lower down as they were out of control over the recent months. The spread has fallen nearly 310 basis points as of June and are now 200 basis points below the 25 year average. This is very close to the lowest level, seen 25 years ago, of 250 basis points. With that said, since this started, the spread has jumped well over 400 basis points.

It is time to look at being long with U.S. junk bond debt as a crowded trade. This can also can be said with being long on the U.S. dollar. The yields on high higher-yield (junk) bonds have been moving higher and higher with the average yield on the comparative sector indexes falling. These are now at a record level of five percent, as of June. They have since recovered, but still low at nearly six percent. We have seen nearly $30 billion dollars of capital move out of junk bonds, meaning lower prices and higher yields.

Is this now the time to buy? Maybe. Risk and reward is now more attractive than it was last year or a year ago. Morgan Stanley (MS: NYSE) has since moved to a “recommendation” on these bonds while lowering its rating on BB-, B- and CCC rated paper (“paper” is another way to say “bonds”). With that said, high yield bonds are cheap making them easier to buy. This is has not been the case over the past year. This makes them an attractive asset when looking at the other asset classes.

Okay, let’s look at the bottom line. Just because some air has come out of the junk bond market, does not mean there is not a significant bubble in place. The selloff is far from done as the spread, between junk and Treasuries, is still very depressed. This means this spread is likely to move higher. This will be moderate and not a leap higher but there is still a significant bubble here. No brainer to see that!