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Own corporate bond funds? Time to take profits Add to ...

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Investors were richly rewarded for piling into corporate debt issues in the low rate environment following the financial crisis. Now, however, there are increasingly dark clouds on the horizon, and it appears the corporate bond investment theme has run its course.

The difference between high-yield corporate bond yields and government bonds, also known as the spread, is the primary measure of attractiveness for corporate bonds. The sector is considered cheap when spreads are high and corporate bonds offer yields well in excess of government ones.

As a whole, the corporate bond sector is now much less attractive relative to government bonds. At 3.0 per cent, the spread is at its lowest since July 2007.

Investors who own individual bonds are likely okay. Their main risk is that the issuing company defaults on the debt and, with the possible exception of bonds issued by financially weak junior mining companies, there are few signs of rising default risk.

The risks are much higher for those holding corporate bonds through ETFs, mutual funds or structured products.

The danger is that selling in the sector could intensify if investors decide that equities offer better upside, or that high yield bonds are too risky for the price they currently command. The rush to the exits could cripple corporate bond prices and send yields sharply higher.

In the past, the major banks on both sides of the border supported the corporate debt markets by buying during sell-offs, adding to their large inventories. But the banks are unlikely to help out this time. According to Citi credit strategist Matt King, interest in corporate debt has been so intense among U.S. investors, the size of retail investor holdings now dwarfs the large U.S. banks’ ability to pick up much slack.

In Canada, credit insiders are also reporting declining liquidity in the corporate bond market – domestic banks are reluctant to increase the size of their inventories. One specialist told me there were times in 2013 when even investment grade Canadian corporate debt issues were going “no bid” – attempts to sell them met with no demand. There’s no open market for corporate bonds. For all intents and purposes, the banks are the only place to sell.

At this point, we have a market sector that’s expensive, that has arguably grown too large relative its prospects, and where the usual bid support may not be there if a sell-off begins. Investors in pools of corporate debt should definitely consider taking some profits.

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