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Summary High yield bonds were conspicuously absent from the capital market rally on Friday. It is worthwhile for investors to take a look under the hood and consider exactly what they are getting when they are buying into high yield bond market. Risks remain biased to the downside for the asset class. Global capital markets had a marvelous trading day to close out the week on Friday. Almost everything traded strongly higher to close out the week including widely divergent categories such as U.S. stocks (NYSEARCA: SPY ), U.S. Treasuries (NYSEARCA: TLT ), gold (NYSEARCA: GLD ) and copper (NYSEARCA: JJC ) all posting robust gains. But one asset class was conspicuously absent from the party on Friday. It was high yield bonds (NYSEARCA: HYG ), and the fact that this category could not even squeeze out an incremental gain with the rest of the market surging raises an eyebrow to say the least. Given that so many income starved investors such as retirees have found themselves increasingly allocating to this category in recent years in the desperate search for yield, it is worthwhile to take a look under the hood and consider exactly what investors are getting when they are buying into high yield bond market. High Yield Bonds: Not Your Grandma’s Bond Market Many investors fall victim to a common misconception. Stocks are exciting and bonds are boring. Stocks are for those interested in achieving capital growth, while bonds are a safe way to invest and earn some income. Thus, when they see the word “bonds” included in the “high yield bonds” moniker, they make the assumption that these investments are safer than being allocated to stocks. And professionals having thrown around statements like “historically low default rates” in the recent post crisis years has only served to reinforce this potential misconception that high yield bonds are a generally safe place to park your money and capture a meaningfully higher yield. But this is not the case when it comes to high yield bonds. In fact, high yield bonds behave much more like stocks than traditional bond categories like U.S. Treasuries. For example, since the outbreak of the financial crisis in 2007, the high yield bond market has had a +0.74 returns correlation with the S&P 500 Index versus a -0.11 returns correlation with the U.S. Treasury market. In other words, high yield bonds more often than not follow the returns path of the U.S. stock market, not the traditional bond market. This strong relationship between high yield bonds and stocks, not Treasuries, is demonstrated in the following historical returns chart during the financial crisis. For while stocks were plunging lower and U.S. Treasuries were rallying, high yield bonds followed the stock market lower. And when stocks bottomed and started rallying in March 2009 as U.S. Treasuries were cooling, high yield bonds began to rally sharply along with the stock market. (click to enlarge) When High Yield Bonds Become Junk OK, so high yield bonds act more like stocks than bonds. In many market environments, this is a wonderful characteristic that makes them an ideal asset class to own as part of a diversified portfolio strategy. And the name “high yield bonds” certainly sounds welcoming enough. Hey, one might say, I’m making an investment in a bond that is going to earn me a higher yield. Indeed, this is true. But there is no free lunch when it comes to investing or anything else. These bonds are providing investors with a higher yield for a reason. And when it comes to high yield bonds, this higher yield is more often than not due to the fact that an increased default risk is associated with the bonds. After all, these bonds were once widely known as “junk bonds” for good reason. Of course, investing in something that is called “high yield” is a lot more appealing than something that is called “junk”. And the threat is starting to build that they may once again make good on their old fashioned name. During periods of economic prosperity, the default risk associated with high yield bonds (NYSEARCA: JNK ) is typically low. This can also be true during periods of freely flowing liquidity in the financial system. Unfortunately for investors, these low default rate periods can breed complacency, for it does not take long once underlying economic and/or financial market conditions to deteriorate before junk bond default rates start spiking higher. For example, during the period from 1992 to 1998, the default rate on high yield bonds was consistently less than 2%. But after moving meaningfully higher in 1999 and 2000, the default rate spiked toward 13% in 2001 and over 16% in 2002. Putting this in perspective, one out of every eight high yield bonds defaulted in 2001, and for those remaining issuers that did not default in 2001, one out of every six defaulted the next year in 2002. Putting this in yet another perspective, imagine having a ladder of six attractively yielding certificates of deposit (CDs) at your local bank and learning at some point in time that one of these CDs would only be getting paid back at 40 cents on the dollar, or maybe even less, or perhaps hardly at all. From 2004 to 2007, high yield default rates returned to lows below 4%. But once the financial crisis began to set in, credit risk began to explode higher once again. In 2008, the high yield default rate pushed toward 7% and by 2009 it was spiking toward 14%, or one out of every seven high yield bonds. These default rate swings are nothing new for the asset class, for they have been known to periodically occur going all the way back to when they were first entered into the capital markets mainstream leading up to what is now referred to as the junk bond crisis of 1989. None of this is to say that high yield bonds are not an outstanding asset class that has their place in a broader asset allocation strategy. But like many categories they have their periods over time of strength and weakness. And high yield bonds are among those that are exposed to greater risk, particularly event risk, than many other categories due to their reliance on lower quality credit issuance. And it seems that we may be increasingly moving toward such a period of weakness for the category today. Where Are We Today? Today, high yield bonds have returned to their sanguine ways. Since 2010, the default rate has remained consistently below 3%. That is, of course, until 2015 when this rate has crept higher toward the 4% level. Is this recent shift higher in default rates foreshadowing more trouble ahead? Only time will tell, but one has to look no further than the option adjusted spreads of lower quality high yield bonds over the past year. This trend certainly does not bode well, particularly since the high yield bond market does not have a Fed frantically rushing to the rescue like in 2011. Instead, they have a Fed that remains determined to raise interest rates. (click to enlarge) This helps explain why the high yield bond market had not participated at all in the recent stock market rally. For while both U.S. stocks and high yield bonds had been moving lower generally in lockstep with one another since the stock market peak back in May, they began to diverge in late October with stocks rallying higher while high yield bonds continued to falter. For U.S. stock investors, this recent deviation should be troubling, as failure in the high yield bond market has been known to spill over by eventually applying downside pressure to other asset classes including stocks. (click to enlarge) What Junk Is Inside My High Yield Bond Portfolio, Anyway? So what exactly are investors getting when they buy into the high yield bond market. Let’s take a look at some of the individual names. The following are some of the largest holdings from the iShares iBoxx High Yield Corporate Bond ETF. HCA (NYSE: HCA ) Ally Financial (NYSE: ALLY ) Frontier Communications (NASDAQ: FTR ) Sprint (NYSE: S ) Tenet Healthcare (NYSE: THC ) Navient (NASDAQ: NAVI ) Clear Channel Outdoor (NYSE: CCO ) Together, these eight companies make up 12%, or roughly one-eighth, of the high yield bond market by this ETF product’s measure. Included below are the recent stock price charts for these same securities. Also included for good measure is the stock price chart of Linn Energy (NASDAQ: LINE ). While this credit does not rank among the top ten holdings in the HYG, it in many respects serves as a poster child for the challenges that over the past year have plagued the energy sector, which makes up 13% of the entire high yield bond market. Why are we looking at the stock prices of these companies whose bonds are included in the HYG? Because the stock price still represents the market’s view on these companies. And if the stock price is falling precipitously enough, it begins to also make a statement about how investors perceive the liquidity and solvency of the company going forward. (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) What we see from the above charts are representative companies from the high yield bond market that have seen their stock prices recently fall anywhere between -20% to -95%. This raises several key points. First, signs of underlying weakness in high yield are no longer confined to the energy space. The list of companies shown on the above slide set are sourced from a diverse array of industries. And they are all performing poorly to varying degrees. Second, the extreme price volatility along with the sudden sharp downside across a range of high yield bond names including those shown above should at least raise questions about the suitability of a major allocation to high yield bonds in the portfolios of many retirees. Given the characteristics of the stocks of these companies, are these the types of names that are best suited for those investors that cannot sustain a measurable loss in value. Lastly, one could understandably counter the point above by stating that investors are putting money into the bonds of these companies, not the stock. Thus, by moving up the capital structure they are protecting themselves from the extreme downside risk associated with holding the stock. Indeed, this is true, but only to a point. For yes an investor is better served to move up the capital structure to hold a credit that will likely have some residual value in the event of a bankruptcy instead of holding the equity and receiving nothing, but for the investor that can ill afford to see as many as one out of every six credits in their bond portfolio enter into default, getting paid thirty to forty cents on the dollar at best is little consolation for people like retirees that are living on fixed incomes and cannot tolerate exposure to downside even remotely near these levels. Sure, these discounts can provide great upside opportunities for investors in the know, but for many retirees, they are not necessarily well positioned or suited to engage in the art of distressed debt investing with their retirement savings. Recommendations The high yield bond market is finding itself increasingly under fire. It has been steadily weakening in recent weeks despite the broader stock market rally. And underlying fundamental conditions for the asset class continue to deteriorate. While the last several years during the post crisis period have proven kind to the asset class, default rates are now creeping higher. As a result, it stands to consider as we move toward the end of 2015 and into 2016 whether high yield bonds will make good on their previous identity as junk. For more conservative investors, now continues to be a reasonable time to consider scaling back existing exposures to the high yield bond market. For the more assertive investor, a short allocation (NYSEARCA: SJB ) to the high yield bond market may have increasing appeal as conditions in the junk bond market continue to unfold. Disclosure : This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.