LONDON, Dec 6 (Reuters) - Crowded junk corporate bond markets may be most vulnerable to what could be the main outlying risk of 2014: a Federal Reserve that is slow to withdraw monetary stimulus and forced to play catch-up.
Juicy yields and low default rates have lured return-hungry investors to the risky high-yield market, which has seen inflows of $20 billion globally this year.
Companies issuing such debt tend to have weaker balance sheets and higher default risks than top-rated ones issuing investment-grade bonds, so typically pay higher yields to attract interest.
So strong is investor demand that sales of junk bonds have set records even after the Fed caused a jolt in May by hinting it would reduce its bond buying.
But next year, a nasty surprise on U.S. monetary policy - as witnessed in 1994 - could deal a bigger blow to the buoyant junk market than to emerging debt, which has already seen a sharp sell-off since May.
Tanguy Le Saout, head of European fixed income at Pioneer Investments, says an average monthly rise in U.S. non-farm jobs of 300,000 and a high inflation reading for two consecutive months could stoke fears that the Fed is behind the curve and trigger unexpected policy tightening.
"The big pain trade will be... suddenly the market says the Fed is behind the curve. The biggest risk is this happening in the first week of January. No one is prepared and you have a perfect storm," Le Saout said.
"High-yield seems to be at more risk than emerging markets. The sell-off in Q2 and Q3 has shaken the tree and let some weaker positions fall to the floor. But in high-yield markets there's a question mark and supply almost outruns the demand."
In early 1994, a build-up of inflationary pressures prompted a surprise Fed Reserve interest rate hike. U.S. yields rose 150 basis points in about a month, sending the S&P 500 stock index down 10 percent in the process.
For now the Fed is seen far from raising interest rates, let alone scrapping the bond buying programme in a hurry, mainly because some measures of annual inflation have been trending well below its 2 percent target.
However, investors are growing nervous. The benchmark 10-year Treasury yield hit a three-month high of 2.87 percent on Thursday after strong jobs and growth data. Many expect the Fed to begin paring bond purchases in March, but an increasing number are betting on January.
"There's room for bond yields to go higher next year (by) around 50-70 bps. But the Fed has to fine-tune so the move is done gradually," said Cesar Perez, chief investment strategist for EMEA at JP Morgan Private Bank.
Data from Bank of America-Merrill Lynch shows global high-yield bonds saw inflows in 10 out of the past 11 weeks as of Nov. 20, attracting some $20 billion, or 0.4 percent of total assets since January.
In contrast, emerging debt has seen eight straight weeks of outflows, with year-to-date redemptions amounting $10 billion, or 0.6 percent of total assets.
As a result, high-yield debt is looking more expensive. Average U.S. high-yield spreads over Treasuries stand at 419 bps, compared with a spread of 357 bps in hard currency emerging debt.
Junk issuers also tend to be more sensitive to tighter funding conditions than top-rated companies with healthier balance sheets.
"High yield is definitely a problem, particularly in the U.S. because you have a lot of retail participation through funds and ETFs (exchange-traded funds)," said Chris Goekjian, chief investment officer of hedge fund Cheyne Capital.
He said the iTraxx Crossover index of mostly junk-rated companies may widen from current levels of around 330-350 bps .
"It may be priced appropriately for now, but if you look forward and you've got growing economies and you've got interest rates going up and so on, then you should see an increase in that," Goekjian added.
Bumper sales are also weighing on prices. Thomson Reuters data shows companies globally have issued $447 billion of high-yield bonds so far in 2013, up 20 percent from the same period last year. This is the highest year-to-date issuance since records began in the 1970s.
The largest deal was by Sprint, whose sale of $6.5 billion of paper in September marked a record for the U.S. market.
Additionally, default rates may rise from current lows as the Fed prepares to withdraw stimulus.
The trailing 12-month global high yield default rate stood at 2.8 percent in the third quarter, down from 3.3 percent last year and below the historical average of around 4.8 percent, according to rating firm Moody's.
(Editing by Toby Chopra)