By Timothy Strauts

With record fund inflows in 2012, investors clearly have an appetite for high-yield bond funds. The strong investor demand lowered credit spreads, and the high-yield category returned over 14% last year. While yields have been falling, high yield is the only bond category with a 12-month yield still above 5%. After four consecutive years of positive returns, is now the time to allocate money to high yield, or is the sector fully valued and ripe for a fall?

Market Expectations
Fitch Ratings and JPMorgan are currently projecting a high-yield default rate of 2% or lower, below the long-term average default rate of 4.8%. These predictions are based on United States gross domestic product growing at 2% and the European debt situation stabilizing. With the average high-yield bond trading above par and below-average credit spreads, there is not much capital appreciation available, so returns will come predominantly

I am sure the numbers being reported regarding individual investors rushing into high yield bond funds are true. However, I am not sure the correct facts are being circulated.

The main narrative that has been reported everywhere from Barron's to the Financial Times is that net inflows into junk bond mutual funds are at record highs. At the same time the reports say that the new high yield bond issuance in dollar terms has never been higher, and yields on junk bonds have never been lower. This leads to the conclusion that retail bond investors are causing a bubble in junk bonds.

I think both narratives are incorrect, and I have not seen any stories that include what I believe are the most important facts.

Almost all the media coverage has the following chart, or similar stats, regarding the inflows into high yield bond funds. The following chart is taken

By Rom Badilla, CFA

There are many headwinds that could plague markets and keep investors awake at night in the weeks and months ahead. The European Debt Crisis, the Fiscal Cliff, weakening corporate earnings and the muddle through U.S. economy are reasons that could create volatility and uncertainty around the market place. Such scenarios could lead to a selloff in risk assets like credit and equities and into safe-haven securities like the dollar and U.S. Treasuries.

Contrary to these risks, the Fed’s recent initiative to expand their balance sheet via Quantitative Easing is generally supportive of corporate bonds and equities due to better financial conditions. As we had talked about, the Fed’s purchases of Mortgage Backed Securities and the subsequent richening of the asset class via declining spreads or the incremental yield over Treasuries, should lead investors to sell their holdings and look to other sectors for yield. Sectors