Junk bond market had given investors great return in both 2009 and 2010.  With junk yield approaching historical low, one of the greatest short opportunities starts to take shape.

The memory of the great credit bubble burst in 2007 is still fresh .  Back then, junk bond spread (with comparable treasuries) reached its lowest point in history, about 2.6%.  Now the yield spread stands in 4.5% range – looking relatively high and indeed the spread may go even lower – This is exactly the argument from junk bulls.

But a simple analysis clearly defies bulls’ logic, in favor of junk bears.

First, interest rate is at historically low.  It can only go up in the future, regardless whether it’s due to true economic recovery or because high inflation forces interest rate to rise.  When the Fed reverses its monetary policy, bond market will be hit hard.  Junk bond, with its bigger default risk and higher volatility, will be hit hardest.

Second, if the economy instead turns southward, entering a period of protracted low growth, mimicking Japan after its housing bubble burst, then the default risk will rise sharply.  By then, Bernanke co. may print more money, but it won’t matter any more.  Ask yourself: What real effect have QE1 and QE2 really had on the economy, besides popping up asset prices?!

For investors, timing again is important. Watch the Fed’s move and hear their talks- any sign of rate hike will be the trigger.

This short video from Financial Times gives you a nice  historical perspective on the junk bond market.

(click on the graph to play the video).