For the week ended August 6th (fund flows are often reported with a bit of a lag) the high-yield (or “junk”) bond market saw net outflows of $6.5 billion bringing to a close a four week stretch of net redemptions totaling $12.5 billion. The cause?…likely the pick up in chatter over recent months about “froth” in the sector following a multi-year bull market.

To understand the current state of the high-yield bond market is helpful in assessing why you own these securities and what your expectations should be going forward.

Strong investor interest has pushed prices up. Similarly the “yield spread” (or difference between the yield on “risk-free” Treasuries and the yield on junk bonds) is near all-time lows. Recently the average spread for the Bank of America High Yield Master II Index was observed around 420 basis points (4.2%) vs. a historical average closer to 590 basis points (5.9%). These low spreads mean investors are getting paid very little to assume the risks associated with high-yield bonds compared with relatively risk-free Treasuries.

There are several factors driving these results. Investors are more confident in corporate balance sheets. Consider that issuers of high-yield bonds are currently experiencing low defaults rates near 2% relative to the historical average of 4% (and much lower than the near 10% rate following the 2008 credit crisis). As a result yield-hungry investors have flocked to the sector to generate additional income and total return than available with more traditional fixed-income investments

There’s no telling how high-yield bonds (or any security!) will perform in the short-term so having an understanding of the range of long-term outcomes is a great way to manage expectations.

In a best-case scenario corporate fundamentals remain strong. Investors will continue to earn a steady stream of high coupon payments. Capital appreciation will likely be limited, however, as there is little room for spreads to tighten. (Remember that as bond prices rise yields fall – credit spreads are already below historical averages so there’s little room to go much lower.)

What is the worst-case scenario? A deterioration in corporate fundamentals combined with a sharp and/or unexpected rise in market interest rates. The result would likely be a flight to safety. The selloff would push bond prices lower and could generate a liquidity concern given the leverage used by many mutual fund managers.

Given this asymmetric risk in high-yield bonds (more downside than upside) it’s important that investors understand why they own high-yield bonds and what their expectations are going forward. The expected increase in volatility is the price to be paid when using high-yield bonds as a substitute for core bond holdings.