Junk Bonds' Strength Belies Balance Sheets

While the stock market has stagnated this year, investors haven't rejected the idea of taking on risk.

In fact, junk bonds -- corporate debt that carries a high yield -- have returned 5.01% this year, as measured by Merrill Lynch's high-yield Master II index. That compares with a 0.5% gain for the S&P 500 and a 3.43% return from investment-grade bonds.

Although mutual funds have actually been net sellers of junk bonds this year, according to data from the Investment Company Institute, analysts say pension funds and other big institutions have been getting in, as default rates have fallen to cyclical lows.

But with questions now swirling about the strength of the economy and a third interest rate hike on the way later this month, some analysts question whether high yield is still a good place to be.

"There is little remaining upside with growing risks on the downside," said Jeffrey Buck, chief investment officer at Homrich & Berg.

While profits as a share of nominal gross domestic product are about as high as they've been in 30 years, Buck said investors have already priced in the news. The spread, or difference between the average junk bond yield and the yield on the 10-year Treasury, is tight at just 373 basis points, and it isn't expected to narrow much further this year.

"Precisely because corporate profits have been so strong, high-yield spreads are tight and leave little room for price appreciation through spread compression," Buck said.

Bond prices rise when yields go down, and vice versa. In 2002, junk bond spreads jumped to over 1,000 basis points, as investors demanded compensation for record-high corporate defaults.

Although the default risk has fallen to under 3% today from more than 10% two years ago, Lance Roberts, an investment strategist at Streettalk Advisors, said he is still wary about high yield because corporate balance sheets are much less healthy than conventional wisdom suggests.