Watch out for the junk bond boom

Junk bonds offer investors solid returns with slightly relatively low risk and very little volatility. But what happens when everyone on Wall Street is buying them?

Lauren Donovan/The Bismarck Tribune/AP/File
Junk bonds may look enticing, but they shouldn't be all investors are buying, Brown argues.

On The Street, we call junk bonds "chicken equity" in the context of portfolio construction.

Many allocators are buying junk bonds not as part of their fixed income allocation but really in search of an almost-equity return with slightly less risk and volatility.  So, for example, you'll see a financial advisor carve out a 5 or 10% spot for junk bond index ETfs (HYG, JNK etc) but that allocation won't be coming from the bond side of his clients' portfolios, it'll be coming from the stock side.

He's re-risking a bit to get slightly more aggressive - without quite going so far as to buy stocks and throw off his precious 60-40 mix

But now what happens when you get a lot of people doing this all once - interest rates and fears about stocks being what they?  You get a deluge of cash into the asset class.

Check this out from Brendan Conway at Barron's Focus on Funds:

Two things...

First, you know what the next step is should the chicken equity trade treat these allocators well, right?  It's more actual stock exposure most likely.

Second, Brendan makes the point that ETFs now account for 10% of all high yield bonds.  In other words, should the going get rough, not everyone who's put this trade on is going to be able to get liquid at once.  Especially during a panic.

We've got a smidge of junk exposure via ETFs in one of our income models, but we're certainly not using it as a "chicken equity" play.  We prefer stocks as opposed to stock-like bonds right now.

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