High-yield or ‘junk’ bonds are debt securities offered by companies considered to be poor credit risks. These bonds offer attractive returns in the form of high coupon payments. Like other bonds, they also offer appreciation potential.

High-yield bonds have enjoyed wonderful rates of return over the past few years. This has been due to two main factors. First, the strong economy and its resulting low default risk have made investors more comfortable with owning junk. Second, yield-hungry investors have found them an attractive alternative to low-yielding money market funds and Treasuries.

However, recent money flows out of junk bonds suggest that the party might be over. To understand why, let’s take a look at the two main factors that impact junk bond prices: credit risk and interest rate risk.

Credit risk refers to the financial health of the bond issuer. A strong economy suggests stable to improving financial health which equates to a decreased probability of default. Conversely, a slowing economy suggests declining corporate financial health which equates to an increased probability of default.

Interest rate risk tends to be a non-issue when investors have other alternatives to junk bonds. To attract investors, junk bonds offer increased yield over safer investments. However, when junk bonds are in favor, the excess demand relative to supply pushes prices up and yields down.

Credit risk isn’t a big concern at the moment with defaults low and the economy improving. As such, the spread between junk bond yields and Treasury yields has narrowed to the tune of 10 percentage points since 2002 to a level well below historical norms.

The result is that interest rate risk might be creeping up. The current environment of high junk bond prices suggests they aren’t offering added yield to compensate for the relatively poor financial health of the issuers.

Interest rates are clearly headed up. Moves by The Fed have yet to impact the long end of the bond market. However, continued rate hikes (or the threat of inflation) would certainly impact long rates.

How much junk bonds would suffer from rising rates might best be measured by looking at duration which provides a rough estimate of loss per 1% increase in rates. A junk bond (or junk bond fund) with a duration of 6 years would lose roughly 6% if rates were to tick up by 1 percentage point. Overall losses could be much greater with higher defaults caused by a slowing economy resulting from higher rates.

Losses are a real possibility given historically low junk yields. Consider that two popular junk bond funds – one from Vanguard and the other from PIMCO – sport yields of 6% and 6.5% respectively.

In sum, it’s tough to recommend plowing new money into junk bonds given the high risks and low potential rewards. While they can add diversification to a conservative, high-quality bond portfolio, their percentage allocation within portfolios should be curtailed to lock-in profits and trim positions that have grown too large on a relative basis.

Finally, as we’re always apt to do, we remind investors not to let taxes be the ‘tail that wags the dog’. With long-term capital gains rates at 15%, keeping 85% of the gain is better than 100% of a vanishing profit.