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Ultra-low interest rates globally have spurred investors to chase yield in ever riskier corners of the bond market, but some are starting to pull out of the race into high-yield papers.
"We take our exposure in high yield bonds to zero, and keep the proceeds in cash," Julius Baer, which has around $409 billion in total client assets, said in a note Wednesday. "Speculative-grade bonds have become expensive and are facing serious liquidity challenges."
Julius Baer isn't alone in heading for the sector's exits. Around $6.34 billion has flowed out of high-yield bond mutual funds and exchange-traded funds over the past four weeks, although a net $17.15 billion has flowed in so far this year, according to data from Jefferies.
High-yield bonds, otherwise known as speculative grade or junk debt, are issued by companies with a rating of 'BB' or lower from Standard & Poor's or 'Ba' or below from Moody's. They have a higher risk of default compared with investment-grade debt, but traditionally offered higher yields as compensation.
Julius Baer is concerned that as regulators "tighten the screw" on banks, it will limit their ability to provide liquidity in the high-yield bond market.
"Liquidity conditions could become as precarious as in late 2008," it said. "If investor sentiment worsens, their low liquidity means that we would not be able to get out in time."
It's also worried about stretched valuations and the weakening of corporate balance-sheet quality.
With speculative-grade, or junk, bond yields hitting all-time lows earlier this year, Julius Baerbelieves the returns aren't enough to compensate for potential default risks. It noted the average yield for the Bank of America-Merrill Lynch high-yield index for U.S. dollar bonds has fallen to 5 percent, from 20.8 percent in early 2009. At the same time, the segment's default rate is expected to rise to 3 percent in the next six months, the banker said, citing Moody's data.
It's also concerned about the recent wave of mergers and acquisitions (M&A), with around 40 percent of the proceeds of new high-yield bonds used to finance mergers, up from 10 percent in 2009.
"We have seen in the past that a wave of defaults follows an M&A-related surge in leverage, with a certain time lag," it said.
The private banker is in good company in seeing junk bonds as expensive. In July, Federal Reserve Chief Janet Yellen told a Senate committee that "In some sectors, such as lower-rated corporate debt, valuations appear stretched and issuance has been brisk."
High yield corporate bond deals worth more than $1 billion have hit a record since the start of the year, according to research firm Dealogic.
In addition, Bank of America-Merrill Lynch's survey of fund managers for July found U.S. high-yield debt is considered the most crowded trade.
Others are also pulling out of the segment.
"We have reduced high yield bonds as valuations are rich and may not reflect the underlying credit risk," Credit Suisse private banking said in a note dated Tuesday. "Proceeds were reinvested in investment grade bonds."
While yield spreads in the segment have widened a bit in July, more is needed before it would restore value, it said.
"We suggest using any renewed narrowing to reduce exposure to low quality credits and move higher in the credit curve," it said.
—By CNBC.Com's Leslie Shaffer; Follow her on Twitter