The high-risk fixed income market that usually offers a healthy risk premium over the investment-grade bonds has seen shrinking yields this year as rising confidence about the economy, low rates and recovering balance sheets have lures investors of all stripes into the junk-bond market.

Junk bonds were first set in a separate category in the $4.6 trillion corporate-bond market in the 1980s. This year investors have seen impressive price gains in the market in combination with shrinking yields. In 2004 the return on junk bonds was 10.5%, according to the Bear Stearns High Yield index, and the average yield was at its lowest since the benchmark was created in 1985, 6.9%.

"There’s an extraordinarily high level of risk tolerance in the high-yield bond market," says John Lonski, chief economist at Moody’s Investors Service. "We’ve been saying for some time that the end [of the rally] is near."
Junk bonds have always been attractive as the returns matched those on stocks while the income remains fairly predictable. Optimists argue that the massive defaults of junk-bond issuers are not yet in sight. On the contrary, the annual default rate for issuers of high-risk debt has dropped to 2.6% in November as opposed to the average of 4% over the latest four quarters, according to Standard & Poor’s.

The riskiness of these investments as compared to the level of 1997 or early 1998 has increased. At the end of the third quarter, about 37% of junk bonds outstanding were rated B3 or lower as opposed to 31% in 1997.
"It’s not a good time to get involved" in junk-bond investments, says Michael Taylor, high-yield strategist at Bear Stearns. "There’s not much upside left."