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Surge in High-Yield Bonds a 'Big April Fool's Joke'

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An increase in the issuance of high-yielding bonds alongside leverage to purchase this debt has sparked renewed fears of a bubble in the credit markets, with one bank warning investors of the threats involved.

Coutts, the private bank used by Queen Elizabeth, sent an internal communication to investors warning of a potential collapse of the high-yield markets.

The bank's investment strategy committee has become concerned that some of its wealthy customers, predominately in Asia, have borrowed money to enhance their returns from these high-yield investments.

New rounds of quantitative easing (QE) by the world's major central banks have pushed sovereign yields to record lows and driven yield-hungry investors to bonds with lower credit ratings.

"This is a credit boom and credit booms always end badly. But they typically don't end until people become over leveraged," Brian Reynolds, chief market strategist at Rosenblatt Securities told CNBC Tuesday. "Today's the day after April Fool's Day and it seems for many investors that the last four years have been a big April Fool's joke."

(Read More: Junk Bonds: Best in Class or Dangerous Bubble?)

Fears of a high-yield bubble were raised at the end of last year by the Bank of International Settlements which warned fixed income prices had reached unusually high levels that didn't reflect the weakening in the global economy.

But demand for high-yield debt has continued unabated with Goldman Sachs launching a new unit to invest in the space, according to a report in the Wall Street Journal on Monday.

With so much demand, companies have also rushed to issue yet more paper, leading to a surge in volumes last month.

(Read More: Bond Frenzy Stokes Bubble Fears in China's Real Estate)

According to LCD, a division of S&P Capital IQ, U.S. high-yield primary market volume ballooned to $34.9 billion in March, the highest level of the year and the heaviest output since October.

"It's not a credit bubble, it's a credit boom. Credit booms lead to bubbles elsewhere, but we're only in the fourth innings of this boom. We are seeing increasing demand from the pensions that are driving these credit markets and have for the last 20 years," Reynolds said.

Historically with credit booms most of the stock price gains come after the Federal Reserve begins to tighten its fiscal policy, Reynolds added.

"We're not even at that point yet," he said. "Our work indicates that even more financial engineering will be coming down the road. And yes it will end badly some day."

Coutts' investment committee warned about the rising risk from commercial property on high-yield debt and singled out a particular type of security called CoCos or contingent convertible bonds. These bonds, aimed at allowing banks to raise capital without diluting existing shareholders, convert into shares if the stock price rises quickly but can be wiped out when a bank's capital falls below a given level.

(Read More: Dow Nears Record, but Is It Just Another Bubble?)

With banks still undercapitalized, the fear is that some of these investments could be wiped out.

"We've long suspected much of the recent volume of CoCos bond have been targeted at retail type investors – high net worth, family offices and such, seduced by their high-yield characteristics," Bill Blain, senior fixed income broker at Mint Partners said in a morning note.

"Banks, senior debt holders, and core equity investors love CoCos because they don't dilute equity – but they aren't buying [them]!"

By CNBC.com's Matt Clinch

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