Is it time to get out of High Yield debt as QE ends and the Fed weighs tightening?

After five years of near-zero interest rate policy and several rounds of QE a sell-off in junk bonds in gaining momentum Junk bonds typically refer to corporate or sovereign debt rate BB or lower by credit agencies. The bonds offer a yield pick-up to US Treasury bonds to compensate for the additional risk of default by the bond issuer. Capital inflows into junk bond portfolios and high yield ETF's were very robust until the Fed began its tapering program. With QE3 ending next month and the likelihood of a rise in the Fed Funds rate sometime next year, the demand for junk bonds is falling. Recent surveys show investors are exiting junk bonds for fear that higher rates could result in increased corporate and sovereign defaults. Junk debt will underperform when the Fed tightens and investors have been liquidating holdings in anticipation of a higher Funds rate. Hedge funds and sovereign wealth accounts started moving out of junk in the spring, and smaller retail investors joined the selling in late July. The exodus from PIMCO of ‘Bond King” Bill Gross has raised fears that selling will intensify as investors shift out of PIMCO's Total Return Fund. These fears will most likely prove to be misguided. No one individual or fund can overshadow the fundamentals in the economy and marketplace. Mr. Gross's departure may cause a temporary widening of credit spreads in the high yield market. But in the long run sophisticated investors will scoop up those bonds that have become too cheap. Two important fundamentals will guide the performance of the high yield debt market going forward: credit quality and liquidity. As the exodus from junk has gained momentum, the sell-off in better credit rated paper has been hurt as much as lower rated corporate debt. Specifically, debt rated BB has sold off just as much as lower rated CC or CCC paper. The fact is all junk is not created equal. What is happening now in the high yield market is an indiscriminate selling of all non-investment grade paper, regardless of how it is rated by a credit agency. This has created an opportunity for sophisticated to move up the credit curve in the High Yield market. As the Fed tightens, a bond rated BB will outperform a similar issue rated CCC, even though they are both considered less than investment grade. It is prudent for investors to distinguish the difference in credit ratings of High Yield investments when deciding how much to allocate to non-investment grade bonds in their portfolio. Investors should keep in mind that high yield markets are not as liquid as they were prior to 2008. The cost of regulation(expenses for legal and compliance) has risen close to 40% per year since the financial crisis. Tighter regulations have also curtailed market making activities. This is an important consideration for investors who are participating in less liquid assets, such as High Yield bonds. Conservative fixed income portfolios should remain aware that the premium returns in the High Yield bond market are not only a function of credit risk. The difficulty in price discovery and lack of liquidity in this asset class is also an important trade-off for their higher rate of return.