Follow the Pros Out of This Yield Play


Stocks were up for a third consecutive day -- barely -- with the S&P 500 gaining less than 0.1%, while the narrower, price-weighted Dow Jones Industrial Average fell less than 0.1%. For the S&P 500, this marks another five-year high -- stocks have not closed higher since the end of Oct. 2007.

The VIX Index , Wall Street's fear gauge, fell 2.5%, to close at 12.66. The VIX is calculated from S&P 500 option prices, and reflects investor expectations for stock market volatility over the coming thirty days.)

On Monday, I highlighted the risks of an overheated junk bond market in This Huge Yield Play is Played Out. Apparently, I'm not alone in believing that this market is overpriced; yesterday, the Financial Times ran a piece titled "Big investors lead bets against junk bonds," according to which, a who's who of sophisticated investors have turned bearish on this market, including GSO, the credit unit of Blackstone, andOaktree Capital, a value-oriented distressed debt specialist. These investors are either paring their exposure to high-yield or, in some cases, even going short.

As one investment executive told the FT:

To be long fixed income -- and particularly high yield -- doesn't make a lot of sense. If you miscalculate on either side you lose. You lose if things are bad and there is a sell-off and you lose if things are better and there is a sell-off. The balance beam is very narrow.

To elaborate: If the pace of the recovery picks up, interest rates will rise, and investors would shift assets from high-yield bonds into equities -- both of which would likely hurt bond prices. Conversely, if the economy stalls, bond defaults would tick up, and investors would prefer higher-quality corporate bonds or Treasuries.

In between both of those economic scenarios, there is a third scenario that does not imply losses for junk bond investors, the "narrow beam" of an economy that continues to just muddle through. However, even that scenario does not allow for much in terms of additional gains for investors beyond collecting coupons, and it has a finite time frame.

Investors who own the iShares iBoxx $High Yield Corporate Bond Fund ETF or the SPDR Barclays High Yield Bond ETF -- it's not a balance beam you're walking, it's the plank -- but there is still time to turn back.

Are you at ease ... or nervous? It's been a great five-year run for investors, with the Dow and S&P at or near all-time highs. Yet, fears abound. When will the next downturn hit? Will political gridlock lead to portfolio-killing inflation? To learn how to protect your portfolio, click here for free guidance from the Motley Fool Pro Academy!

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Fool contributor Alex Dumortier, CFA has no position in any stocks mentioned; you can follow him @longrunreturns. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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