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Whatever happened to the bond market bubble?

The $1.2 trillion high-yield debt market could face a double whammy as spreads tighten and investors use the corporate earnings season starting in the second week of October as an excuse to take even more profits.

"I think there's a huge story in high yield that's been brewing for some time. Even in the non-commodities sectors of high yield," said Michael Contopoulos, head of high-yield strategy at Bank of America Merrill Lynch. "Spreads are too tight. Yields are too rich, and the market is beginning to wake up to the fact that you need to be compensated by more than 500 basis points. That's about 200 basis points lower than where it was in 2011."

The BofA Merrill Lynch high-yield index is trading at roughly 600 basis points versus government bonds, but if energy, metals and mining is excluded, it's about 80 basis points less in terms of spread. The spread has ranged from a low of 427 to a current high of 614 over the past year.

The yield of the overall U.S. high-yield market is about 7.5 percent. The yield excluding commodities is about 6.7 percent.

Recent signals from Washington, D.C., also point to more selling pressure in the high-yield sector.

Fed Chair Janet Yellen emphasized last Thursday that the Fed could raise rates this year, spurring selling in Treasurys and a rally in risk markets. Analysts expect more selling in the credit markets as rates move higher, keeping high-yield issues under pressure.

Pat LaCroix | Stone | Getty Images

High yield could also be vulnerable if political events in Washington create a flight to safety. Analysts are eyeing the potential shutdown of the government next week if Republicans use the budget as a lever to end Planned Parenthood funding. That could cause a ripple in markets, but the real concern is that fight will carry on and Congress battles over the debt ceiling later in the year.

John Boehner's announcement last Friday that he will resign as House Speaker was interpreted by pundits as a move calculated to get a continuing resolution on the budget through now, while pushing a larger budget fight-off into the future.

The pain in the high-yield market has been focused on metals and mining and energy, but that may change, Contopoulos said. Strategists also say the high-yield market has also begun to trade differently, and it hasn't been dependent on events in the Capitol.

"In my view, I think we're overplaying how important the Fed would be in terms of driving the price action. I personally think the market was looking for the Fed to move and get out of the way," said Steve Antczak, head of U.S. credit strategy at Citigroup. "I don't believe a tightening would have caused a selloff. I think what's happened in the last three or four months, the market has become more fundamental."

In recent months, select names in other sectors are seeing yields edge higher, like telecom, wireless and semiconductors. "Before you know it, it is the entire high-yield market. Earnings growth has been anemic. Leverage is at an all-time high," Antczak said.

According to Thomson Reuters, expectations for corporate earnings continue to decline, and now the third-quarter reports for the S&P 500 companies are expected to show a decline of 3.9 percent. In the second quarter, earnings grew by little more than 1 percent, although analysts had also expected negative results.

Energy continues to top the list of sectors with the steepest profit declines. Earnings are expected to fall 64 percent for the S&P 500 energy companies, after a 58 percent decline last quarter, according to Thomson Reuters data. The materials sector also is posed for more pain, with a decline of 13 percent expected. The sectors poised for the best gains are consumer discretionary, financials and telecom, all expected to be up about 11 percent.

"This is the argument from high-yield investors who want to be bullish. They'll say we're down a half percent but the equity market is down 6 percent (this year)," Contopoulos said. "Fundamentals matter, and fundamentals are not great. Global growth matters, and global growth isn't great, and the combination of the two and the lack of QE and the lack of easy policy is not going to be a good recipe for high yield going forward."

The market's selloff has improved valuations, but investors are more cautious, recognizing that there's more default risk. "It's very difficult to identify any positive catalysts in the near term," Antczak said.

The default rate has also increased, led by energy. According to Contopoulos, there have been 13 energy issuers in default this year, bringing the default rate in that sector to 7.3 percent, and he expects more in the next several months. Energy companies will be undergoing bank-lending reviews this month, and the low price of oil will be a factor in eligibility.

"Fundamentals matter, and fundamentals are not great. Global growth matters, and global growth isn't great, and the combination of the two and the lack of QE and the lack of easy policy is not going to be a good recipe for high yield going forward." -Michael Contopoulos, head of high-yield strategy at Bank of America Merrill Lynch

High yield has flourished in the years of low rates and easy Fed policy. Energy was a key beneficiary as the U.S. oil industry struck it rich with new technologies opening up once unavailable drilling opportunities. But the steep drop in oil prices has curtailed the industry's growth, and oil production has flattened out.

"Energy was acting as a deleveraging agent for the rest of the market. When you looked at the overall market, leverage was skewed higher because of energy. If you strip out energy, going back five years rather than five months, the rest of the market was busy releveraging. You had weak earnings growth, but the market doubled in size," Contopoulos said.

"Everybody thinks of QE and easy monetary policy and the biggest beneficiary was the equity market. I would argue the biggest beneficiary of the easy monetary policy was the credit market," he said.