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What Yellen said on junk bonds isn’t what the market heard

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Tech shares were met with a quick selldown on Tuesday after Federal Reserve Chief Janet Yellen said some valuations were "stretched," but similar comments on high-yield bonds got a yawn.

"Markets are going to be very comfortable in risk assets, especially high yield," after Yellen's testimony, said Steve Goldman, managing director at fixed-income manager Kapstream Capital.

Read More Fed, in monetary policy report, says valuations stretched

Investors certainly agreed: Bloomberg's Active High-Yield U.S. Corporate Bond Index slipped a mere 0.07 percent, barely a blip on its 4.9 percent year-to-date gain. The SPDR Barclays Capital High-Yield Bond exchange-traded fund shed just 0.1 percent, or 4 cents, to $41.38.


It's not the expected reaction after the Fed chief singled out the segment for scrutiny: "In some sectors, such as lower-rated corporate debt, valuations appear stretched and issuance has been brisk," she said as part of her testimony to a Senate committee.

Read More The real reason Yellen's comments sent gold lower

It's certainly a different picture on the smaller social media and biotechnology stocks, which Yellen said appear to have "substantially stretched" valuations. The tech-heavy Nasdaq index shed 0.5 percent and the small-cap focused Russell 2000 lost 1.0 percent Tuesday.

But what Yellen said and what the market heard are somewhat different.

"She's also saying the Fed is going to do exactly what markets are expecting, which is not hiking until this time next year and not by very much," Goldman said.

At the same time, while Yellen may be warning investors about taking undue risks, high-yield bonds are generally fairly valued in the current environment, Goldman added.

Others think the lack of reaction in junk bonds was exactly what Yellen wanted.

Read More Don't get too comfortable with low bond yields

"Her objective was to keep markets stable while she explains the Fed's thinking and I think she did that really well," Nizam Idris, head of strategy for fixed income and currencies at Macquarie said, adding that even the equity reaction was relatively muted.

Idris is also not convinced the high-yield sector is terribly overheated, especially compared with the stock market.

"I wouldn't be too negative on high-yield bonds compared to the stocks," he said. "Stocks need to be supported by strong profit numbers. The income statement needs to be strong. Bonds need to be supported by a strong balance sheet," Idris noted. "Right now, most corporates have strong balance sheets, but weak income statements," indicating bonds have more fundamental support.

To be sure, there are some concerns about the sector's outlook.

Read MoreWill yields on high-yield bonds get even lower?

"The next trick for her would be to keep markets stable when she decides to normalize interest rates. That would be the tougher one," Idris said.

Kapstream's Goldman agreed.

"When they start talking about hiking rates, markets will start moving out of risky assets," Goldman said. "You've now created another risk to stability."

While Idris isn't as concerned about high-yield bonds' fundamentals, Goldman has noted a deterioration in underwriting criteria.

The average covenant quality for high-yield bond deals in North America has slipped below the global average, according to data from a Moody's note Tuesday. North American deals are scoring an average 3.55, compared with the global average 3.33 and China's average of 2.57, the data show; higher scores indicate lower quality.

Others see some reasons for concern over junk bonds. Bank of America-Merrill Lynch's survey of fund managers for July found U.S. high-yield debt is considered the most crowded trade.

"Security selection will be more critical than in the past," Goldman said. "A lot of dogs are coming out now."

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1

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