Stay short and favor junk bonds. That, at least, is what’s worked rather well so far this year, based on set of ETFs representing the major slices of US fixed-income markets. But as reflation heats up, is the already stretched high-yield market headed for trouble?

What hasn’t worked is going long Treasuries this year. The deepest loss for the ETF proxies: iShares 20+ Year Treasury Bond (TLT), which is down a hefty 11.8% so far this year.

By contrast, all is well with junk bonds, which have outperformed. The leading year-to-date return for our fund set at the moment: SPDR Bloomberg Barclays Short Term High Yield Bond (SJNK), which is up 2.7% this year (Apr. 27).

Its longer-maturity cousin — SPDR Bloomberg Barclays High Yield Bond (JNK) – is in third place with a 1.1% total return.

The question is how much upside performance is left for junk bonds? The premium in junk yields over Treasuries has fallen to 3.26 percentage points (Apr. 26), based on the ICE BofA US High Yield Index Option-Adjusted Spread. That’s the lowest level in 14 years and a sign that expected return is relatively thin, perhaps even negative.

It’s possible, of course, that junk can continue to rally, especially if interest rates continue to fall. But for the immediate future, rates are trending higher as the Treasury market prices in expectations of firmer inflation. Perhaps that’s a temporary affair, but for now the headwinds appear to be building for junk in the near term.

In a sign of the times, short-maturity inflation-protected Treasuries are the second-best performer this year. The combination of staying cautious by hugging the shorter end of the yield curve and adding inflation protection appears to be a popular trade these days.

“It’s hard to say if inflation is a primary concern right now, but there’s a strong case to be made that inflation could continue to tick higher over the next several years as the economy heats up,” says Douglas Boneparth, president of Bone Fide Wealth in New York.

The Treasury market is certainly pricing in higher inflation lately. The breakeven spread for nominal less inflation-indexed 5-year maturities (a proxy for inflation expectations) is currently around 2.5%. A year ago this spread was close to zero.

Some economists expect that hotter inflation will be a temporary affair. The Federal Reserve appears to be on board with this outlook as it continues to signal that no interest rate hikes are planned for the foreseeable future. Fed funds futures agree and are pricing in low odds of tighter policy for the rest of the year.

Jeffrey Gundlach of DoubleLine Capital sees a different future. “There’s plenty of indicators that suggest that inflation is going to go higher, and not just on a transitory basis, for a couple of months. So we’ll see how the Fed is trying to paint the picture, but they’re guessing.”

For an update on the “guessing,” tune in for today’s new episode of the Fed show (2:00pm eastern), when the central bank releases a new policy statement, followed by Fed Chair Powell’s press conference.

As for what to expect today, Pimco’s Tony Crescenzi sees more of the same on tap. “We’re not expecting changes in the statement or much change in Chair Powell’s posture in the media. We’re not expecting the Fed to give any indication until summer as to what it might do with respect to its balance sheet.”

---

Learn To Use R For Portfolio Analysis
Quantitative Investment Portfolio Analytics In R:
An Introduction To R For Modeling Portfolio Risk and Return
By James Picerno

---