In good news for high-yield bonds, recovery rates on defaults are also improving from the concerningly low levels of recent months, as energy-sector defaults have worked through the system. However, recovery rates are still well below their historical level, which indicates weak bond covenants.

The tightrope walker has his blindfold off, the wind is blowing, and it’s a long way down. Technically speaking, high-yield bond prices broke downward through a “double bottom,” which could reasonably be taken as an indicator of coming trouble for the stock market as well, given the greater wariness among bond market investors this year.

Zero yields could remove much or all of the "hedging value" of Treasuries in traditional bond allocations. Yet another concern for "traditional" bond allocations is less diversification potential (given compressed yields) going into a potential flight to quality. We believe a tactical approach—with a firm willingness to shift to defense...

In late February, our Bond Asset Allocation/Tactical Fixed Income model prompted us to sell out of high yield bonds and instead take up a defensive position. It isn’t enough to simply analyze creditworthiness of issuers or movements in credit spreads. Anyone who thought they were taking a “tactical” approach without a broader analysis was likely sorely disappointed as the latter half of the quarter unfolded.

Since the high yield bond market lows in mid-November, prices recovered and have now moved somewhat above the late-October highs. This process has been slow—and we remained suspect that an intermediate-term trend had not been established.

Inflation may be starting to develop in the U.S., which has significant implications for the High Yield bond market. As inflation takes hold, the Fed’s normal response is to raise policy interest rates to prevent inflation from spiking higher. So what does a period of rising rates mean for High Yield bonds?