Citi Warns It's Time to Lighten Up on High-Yield Bonds

The approaching end of the Federal Reserve's QE2 program in June will put pressure on high-yield corporate bonds, according to an investment research report. That could spell trouble for bond investors.

The approaching end of the Federal Reserve’s QE2 program in June will put pressure on high-yield corporate bonds, according to a report from two Citigroup Inc. researchers.

A research report from Citi's Matt King and Hans Lorenzen suggests that, based on corporate balance sheets, the recent underperformance of high-yield bonds will only worsen in the coming months, according to an article in Business Insider.

According to Citi:

“Putting together the anecdotal information and the statistics, in U.S. high grade, the bondholder-unfriendly stage of the leverage cycle seems only a few quarters away. The pick-up in M&A is U.S. specific (with European companies still being more cautious), and in high yield we are less concerned in any case. But the workings of the leverage clock therefore mean that the underperformance of credit relative to equities, which began in March, is probably only a foretaste of further underperformance to come … It is not so much that we expect a violent turnaround; it is simply that we see little reason to chase the market here, and quite a few reasons to lighten up.”

King and Lorenzen say they don’t believe that there will be a bond market sell-off as a result of the end of QE2 -- the Federal Reserve’s second effort to stimulate the economy by buying Treasury bonds to increase the supply of money. Instead, they believe continued weak U.S. economic data will result in a lack of demand. QE2 has been credited with keeping interest rates low and boosting the stock market. When the first round of so-called quantitative easing ended in spring 2010, the stock and bond markets sank.

From the Citi report:

“It is not so much that we think the end of QE will spark an instant sell-off. Rather, we think the market will be coming off drugs, which meant that sizeable market inflows found simply nothing to buy. If the headlines revert to being positive, then spreads should hold in regardless. But if, as we suspect, they continue to disappoint, investors may find themselves rather shorter of breath than they were when the market was at its peak. For now, we think this rally is running out of steam."