The End Of The Junk Rally
A weak economy means the riskiest corporate bonds have little room left to climb.

After soaring 20% in the past three months, the junk bond market's performance has turned flat. That seems to reflect a growing caution among money managers and fixed-income analysts, who say a sluggish economic turnaround and weak earnings will lead more debt-burdened companies into bankruptcy. If you're hoping to jump on the junk-bond rally, it's probably too late.

The junk bond recovery has likely run its course, said Paul Lefurgey, lead fixed income manager at Madison Investment Advisors, which runs the Madison Mosaic mutual funds. He's telling clients who invested in high-yield bonds to take their profits off the table.

Higher bond prices have lowered interest rates for companies raising cash in the bond markets. Companies sold $15 billion in high-yielding junk bonds in June. The ranks of those tapping the high-yield market this month include Toys R Us, Real Mex Restaurant and Regal Cinemas.

But there seem few reasons left for the high-yield market to climb higher. In a report released this week, the rating agency Standard & Poor's says the "high yield rally could take a summer vacation." The gap between yields on junk bonds and Treasury bonds with similar maturities has fallen at an unprecedented pace this year, from 16 percentage points at the end of 2008 to a recent 10. Economic data and earnings probably won’t provide the good news to propel junk bonds higher and yields lower. S&P has put 40% of all companies with speculative-grade ratings at risk of getting lower grades.

Earlier this year, Lefurgey began selling off Treasury bonds in favor of corporate debt but stayed away from the junk pile. Even now that the market for risky debt has rebounded the average junk bond still yields 13%, an enticing 10 percentage points higher than a Treasury bond. That’s not enough reward for the risks, Lefurgey says -- namely, a rising wave of defaulted debt.

So far this year, 128 companies have missed payments on their debt, according to S&P. In the past week, CCS Medical defaulted when it filed for Chapter 11 bankruptcy protection. The rating agency expects the default rate to top 14% by next March (see, "Deluge of Defaults"). Earlier Friday, Kathleen Shanley of Gimme Credit sent out a note urging investors to sell debt of CIT Group ( CIT - news - people ) due in 2017.