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.