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More and more investors have been attracted to the junk bond market as the bank interest rates are artificially low and the yields on the Treasuries trails inflation. SPDR Barclays Capital High Yield Bond ETF JNK, which tracks the widely followed Barclays Capital High Yield Very Liquid Index, has seen its cash inflow of almost $5 billion since the beginning of 2010.

Amid a continued drop in dividend payout, some financial experts warn there may be bubbles in the junk bond market. One of the arguments that buttresses the claim is that the yield spreads have dropped so dramatically that current returns won't be able to justify the risks investors take in the junk bond market. Before we jump to any conclusions, let's do a reality check.

The most recent recession forced the Fed to lower the interest rate and keep it low for a few years. The ultra low interest rate has given bond issuers more breathing room. New issues can bear lower dividends given the same or lower yield spreads. Even worse, issuers can also repay the callable bonds, pushing investors into lower yield issues. On the credit risk front, the overall default rate of junk bonds has dropped from the peak in 2009 so much so that bond issuers deem the decrease in dividend payout is in line with credit market conditions.

The following chart has shown that the dividend for JNK dropped by 42% in 36 months.

(click to enlarge)
Chart Source: Zumlon Technologies LLC

The yield has almost shrunk 45% since October of 2009 as unabated enthusiasm kept supporting the price in spite of the continuous drop in dividends throughout the 36 month period.

(click to enlarge)
Chart Source: Zumlon Technologies LLC

More prominently, the yield spread between JNK and 10 year T-Note has decreased from 880 bps in October of 2009 to 502 bps in September of 2012.

(click to enlarge)
Chart Source: Zumlon Technologies LLC

One of the reasons behind this is that the overall default rate for the high yield bond market has steadily improved since mid 2009. The diminishing yield spread mirrors the change. In the summer of 2009, the HY default rate topped out at 14%. Now it stands around 3%. Today, owning the JNK ETF may have lower risk than doing it in 2009. The yield spread is still above the default rate plus some premiums.

On the other hand, the current low yield environment may continue to disappoint income-hungry investors. From the top 10 holdings of JNK, we found most of the issues are double B or single B rated by Moody's. In order to enhance the yield, investors have to sacrifice quality of issues. By moving down aggressively to single B and even highly speculative C issues, the yield will be raised so long as investors stand ready to face the default risks.

US852061AK63Sprint Nextel CorporationTelecomSenior Debt9% Guaranteed senior unsecured notes, due Nov 15, 2018BA3BB-
US404121AC95HCA, Inc.Health CareSenior Debt6.50% Senior secured notes due Feb 15, 2020BA3BB
US319963BB96First DataIndustrialSenior Debt12.62% Senior unsecured notes, due Jan 15, 2021CAA1B-
US29269QAA58ENERGY FUTURE/EFIH FINANUtilitySenior Debt10% Senior secured notes, due Dec 1, 2020CAA3B-
US796038AA56Samson Investment CoOil & Gas ServicesSenior Debt9.75% Senior notes due Feb 15, 2020B1B-
US413627BL36CAESARS ENTERTAINMENT OPERATING COConsumer ServicesSenior Debt8.71% Senior notes due Jun 1, 2017B3B
US451102AH03ICAHN ENTERPRISES/FINFinancialSenior Debt8% Senior unsecured notes due Jan 15, 2018Ba3BBB-
US12543DAL47CHS/COMMUNITY HEALTH SYS INHealth CareSenior Debt8% Senior unsecured notes due Nov 15, 2019B2B
US29977HAA86EP ENERGY/EP FINANCE INCIndustrialSenior Debt9.375% Senior unsecured notes due May 1, 2020B2B
US676253AC15OFFSHORE GROUP INVST LTDFinancialSenior Debt11.5% Senior secured notes due Aug 1, 2015B3B-

Data Source: Zumlon Technologies LLC

However, what investors really should do is to look forward to future default rates among issues. Unfortunately, that does not bode well as recent overall HY default rate has begun to edge up near the standard threshold of 4%. Our model has detected some unnerving upward pressure of the overall default rate and expects the rise may continue.

As a predictive indicator, if it keeps on marching northwards, another recession may be looming. Current investors may still be able to load junk bond issues, but the exit strategies have to be well planned ahead.

Source: Is There Any More Juice Left In The Junk Bond Market?