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Investors cut junk bond holdings as debt fears mount

Siegfried Layda | Getty Images

Billionaire investor Carl Icahn is not the only one sounding the alarm bells on high-yield debt, with investing arms of some major investment banks cutting back exposure to the sector on fears that their debt piles are looking unsustainable.

Fears over the health of the U.S. economy and the timing of a Federal Reserve interest rate rise have weighed on high-yield bond prices. Otherwise known as junk bonds, high-yield is issued by firms that are deemed below investment grade by ratings agencies.

While the risk of these investments is high, so are their returns: Junk bonds tend to offer investors at least 150 points or 1.5 percent on top of 10-year U.S. Treasury yields with 10-year U.S. government bonds currently trading around 2.08 percent.

However, UBS wealth management and Citi's private bank division have both cut back their exposure to U.S. junk bonds this month, with both deeming the position no longer worth the risk.

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Global chief investment officer at UBS wealth management, Mark Haefele said the group had trimmed their position from "overweight" to "neutral" for the first time since 2011.

"This asset class is becoming less attractive as levels of leverage have picked up, interest coverage has fallen, and exposure to low oil prices can still impact default rates over the coming 12 months," Haefele said.

At Citi, global chief investment strategist Steven Wieting said while he does not fear for U.S. high yield borrowers away from oil drillers, he has upped allocation to "high grade" debt, one rung below what ratings agencies deem the safest from of debt.

"U.S. high yield debt's correlation to equities is substantially higher, near 63 percent, versus 31 percent for high grade over the past 25 years. At our latest global investment committee meeting, we reduced our high yield overweight slightly to shift to high grade, in line with past steps to gradually raise portfolio credit quality," Wieting said.

The iShares iBoxx $ High Yield Corporate Bond ETF, commonly referred to as HYG, is the largest junk bond Exchange Traded Fund in the U.S., with around $12.85 billion under management has seen prices drop to multi-year lows, sending average yields of the companies tracked by the ETF to around 6.5 percent.

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Using data from xtf.com, Nick Colas, chief market strategist at Convergex said some $37 billion is currently held in U.S. listed high yield across 39 ETFs.

In the last week, around $893 million has been pulled from U.S. junk bond ETFs, mainly from HYG and its competitor State Street's SPDR Barclays High Yield Bond ETF (JNK).

The case for buying junk

Absolute return bond fund manager Jon Jonsson at Neuberger Berman said he started adding to positions in U.S. junk bonds towards the end of last year, having held a short position, or expectations that the price would, fall last summer.

In August this year he added some 10 percent to his portfolio, with U.S. high yield now making up around 17 percent of his fund.

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"Valuations got to a point where I think I am compensated for a higher default rate. I am not saying that default rates are not going up, I would expect that from where we are. But if you look at the simple economics of it, our view on the U.S. economy is we are still looking at it as it continue to muddle through," Jonsson told CNBC.

Jonsson said the "spreads" -- or the difference an investor is paid for high-yield debt compared to U.S. Treasury bonds -- are now high enough to compensate him for the potential default and liquidity risks.

"Spreads have become quite attractive. If the U.S. economy doesn't go into recession and doesn't have a significant growth shock, I think I am pretty good here."

"If we get more comfortable with the U.S. economy we could possibly add," he said.