Like Icarus, many bond investors flew too close to the sun and have been burnt in the high-yield bond market. By over-reaching for higher yields than available in the money markets and investment-grade bonds, they drove the yields on high-yield bonds too low.

The BAML US high-yield corporate bond yield fell to a record low of 5.16% last year on June 24. The carnage since then has pushed this yield up to 9.06% Monday. The yield spread over 10-year Treasurys fell to 253bps on June 23, 2014, the narrowest since June 18, 2007. It was up to 683bps Monday, the highest since November 11, 2011.
 
The rout in the junk bond market was triggered by the broad decline in commodity prices since the summer of 2014, especially the plunge in the price of oil. The rout has been exacerbated by expectations that the Fed would start raising interest rates following the termination of QE at the end of October 2014.
 
What if the markets come to believe that a rate hike tomorrow might be the last for a very long time, and that a rate cut isn’t out of the question in 2016? In this scenario, the dollar should peak and commodity prices should bottom. That could set the stage for another round of yield-reaching next year.

However, be warned that some very smart people are warning that the worst isn’t over for the junk bond market:
 
(1) Gundlach’s warning. “There’s never just one cockroach,” Jeff Gundlach said in a telephone interview Friday. “This volatility in the junk-bond market should easily stay the Fed’s hand, and unless this volatility calms down in the next three days, they’re going to have a hard time raising rates.”
 
(2) Icahn’s warning. “The high-yield market is just a keg of dynamite that sooner or later will blow up,” Carl Icahn said on Friday’s CNBC Fast Money: Halftime Report. Hours after Icahn’s comments, the WSJ reported that hedge fund Stone Lion would block redemptions from a fund, and on Monday Bloomberg reported that high-yield credit fund Lucidus Capital Partners had liquidated.
 
(3) Stein’s warning. One of the earliest warnings about potential trouble in the corporate bond market came from former Fed Governor Jeremy Stein in a February 7, 2013 speech titled “Overheating in Credit Markets: Origins, Measurement, and Policy Responses.” He noted: “The third factor that can lead to overheating is a change in the economic environment that alters the risk-taking incentives of agents making credit decisions. For example, a prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to ‘reach for yield.’”
 
Let’s hope he was right about the following conclusion he provided: “Putting it all together, my reading of the evidence is that we are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit. However, even if this conjecture is correct, and even if it does not bode well for the expected returns to junk bond and leveraged-loan investors, it need not follow that this risk-taking has ominous systemic implications. That is, even if at some point junk bond investors suffer losses, without spillovers to other parts of the system, these losses may be confined and therefore less of a policy concern.”
 
Stein foresaw the following situation, which seems to be unfolding now: “If relatively illiquid junk bonds or leveraged loans are held by open-end investment vehicles such as mutual funds or by exchange-traded funds (ETFs), and if investors in these vehicles seek to withdraw at the first sign of trouble, then this demandable equity will have the same fire-sale-generating properties as short-term debt.”
 
(4) Contrary perspective. For signs of worsening systematic risk in the bond market, Debbie and I are monitoring investment-grade corporate yields. The BAML A-rated corporate bond yield composite has risen 42bps to 4.62% so far this year. Its yield spread over the 10-year Treasury has widened by 56bps to 239bps since early last year.
 
It seems to us that the troubles in the high-yield corporate bond market haven’t spilled over into investment-grade corporates in a major way. This year’s higher yields on investment-grade bonds seem to be related more to the expectations of a Fed rate hike than to deteriorating credit quality in investment-grade bonds. If so, then their yields could come down if the problems in the high-yield market stay the Fed’s hand on additional rate hikes.

Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research. To read more of his blogs, CLICK HERE NOW.