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There is trouble brewing in the North American corporate bond sector, raising portfolio risks for investors on both sides of the border. Low interest rates and easy credit have allowed companies to boost earnings either by buying back shares or lowering interest expenses. An explosion in corporate bond issuance has allowed aggregate profits to climb despite a severe shortage of revenue growth.

There are signs, however, that the party may soon be over. Merrill Lynch Research calculates that investors have removed $1.5-billion (U.S.) from high-yield bond funds in the three weeks ended Nov. 26. The selling has caused "sinkholes" for the price of lower quality debt according to a report from Bloomberg's Lisa Abramowicz.

"[A]sset managers are being forced to exit their riskiest positions, either because of withdrawals or to placate increasingly nervous investors, and they're finding no buyers on the other side," Ms. Abramowicz writes. "When these fund managers finally get an offer to shed their unwanted holdings, they're just taking it, even if it means taking a huge loss."

The end result has been a severe decline in the prices of high-yield bonds. Because bond yields move in the opposite direction of bond prices, yields on high-risk corporate bonds have skyrocketed. The Merrill Lynch CCC Option Adjusted Spread (OAS) index – which measures the yield of CCC-rated bonds minus appropriate government bond yields – has more than doubled since June, 2014 – from 6.27 per cent to the current 15.1 per cent.

These higher yields are extremely bad news for struggling companies (notably in the U.S. shale-oil-producing sector) that have to refinance debt at much higher interest rates as previous corporate bonds mature. Many cash-flow-strapped companies will be unable to afford to pay the higher interest rates required on newly issued bonds.

"[W]e would posit that roughly 35 to 40 per cent of the outstanding U.S. high yield and leveraged loan universe is at risk [of default] … that would imply $750-billion to 800-billion in low quality speculative grade debt," UBS Research writes.

So far, market weakness has been largely confined to the lowest quality bonds. The Merrill Lynch OAS yield index for BBB-rated bonds has climbed a more modest, but still significant, 80 basis points since the lows of June, 2014.

Investors should not get complacent here. Merrill Lynch's most recent "Flow Show" report of Nov. 25 noted the highest weekly outflows from investment grade bonds – the highest quality corporate debt – in two months at $2.8-billion.

Standard and Poor's reports the global corporate debt defaults doubled to 100 in 2015 and the risk is that the default trend has just begun. A rising U.S. interest rate environment, as the Federal Reserve raises interest rates, would make matters worse. When the yield on government bonds rises, investors are motivated to sell higher-risk corporate bonds for the surety of risk-free government issues.

For investors, it is not a good time to own corporate debt with the possible exception of the absolute highest rated issues. In addition, investors should reduce holdings of mid- and small-cap companies dependent on share buybacks for earnings growth. For many of these firms, capital markets may be closed to them in the coming years.

Follow Scott Barlow on Twitter @SBarlow_ROB.