Some observers believe there are danger signs that may foreshadow a melt-down.

The world’s investors were spooked on Wednesday when US Federal Reserve Chairman Ben Bernanke said the Fed may ease up on its controversial bond-buying strategies, which have helped tamp down interest rates and maintain a powerful stock and bond market rally.

For now, the Federal Reserve will continue its program of buying up mortgage and government debt in an effort to stimulate the economy, although Bernanke said purchases may be reduced later this year. That could send shock waves through the bond and equity markets as these props are pulled away and interest rates begin to rise.

Global stock indexes in the US and abroad tumbled on Thursday following Bernanke’s comments. The US benchmark S&P 500 had its worst day since November 2011, shedding 2.5%. European stock markets lost 3% or more by the close.

US junk bond investors, however, had already been nervous. Those who had purchased these lowest-rated bonds issued by companies in a quest for higher returns did so “with great trepidation,” said Martin Fridson, chief executive of New York City-based research firm FridsonVision LLC. “They don’t want to be caught in a rising rate market.”

Investors have pulled $6.5 billion out of junk bond funds this year, according to data research firm Dealogic — most of that within the past few weeks.

But even as investors have fled US junk bonds, European junk bonds have seen resurgence. They have been an attractive option for investors in the US and abroad, in part because of low interest rate expectations and higher protections for investors. As fiscal woes in the euro zone have become less prominent, net inflows into European junk bond funds have totalled $2.4 billion so far this year, versus an outflow of $787 million for the same period last year, according to research firm EPFR Global.

US market bubble?

US junk bonds, usually rated BB or lower — eight notches below a top-rated bond — are generally highly volatile. In addition, they are also the least safe. If defaults start rising, investors become just another creditor in a bankruptcy, subject to pennies-on-the-dollar payouts. Despite the risks, yield-seeking investors have flocked to junk bonds.

 Some observers believe there are danger signs that may foreshadow a melt-down.

Investors’ big appetite for low-grade junk bonds is one such sign. CCC-rated bonds, which are considered highly risky, have chalked up 26.3% gains in the past 18 months, according to a recent Citi Research analyst note. Last autumn, Citi analysts were recommending these bonds. But they have recently shifted their view, advocating a return to higher quality BB bonds last week, in case of a junk bond sell off.

Companies issue junk bonds to raise capital and bolster weak balance sheets. And red-hot demand means there’s more room for marginal issuers to pile on even more debt, which can trigger even lower credit ratings. Speculative-grade companies are most vulnerable to ratings downgrades within the next five years, according to S&P.  

Investors have already been feted to a flood of new issues this year in the US — a total of 366 for the first five months of 2013, versus 279 for the same time period last year, according to Dealogic. But the quality is beginning to deteriorate, with covenants—that is, protections for investors—at their weakest levels in two years, according to credit rating agency Moody’s Investors Service Inc.

Turning to Europe

It all adds up to a more shaky US junk bond market, so some US bond fund managers have tiptoed into European bonds looking for bargains.

“We’ve found very attractive bonds in Europe,” said Dan Fuss, portfolio manager at Boston, Massachusetts, investment management firm Loomis, Sayles & Co, which oversees $191.4 billion in assets. “The market there is developing rapidly.”

The main reason for the European boomlet is a surging new issue market in areas where European banks had typically stepped in to offer financing, but have pulled back. That has led to more companies heading to the European public markets.

“With the credit crisis, local banks have been reluctant to lend to businesses,” said Robert Wheeler, managing director of high yield research at New York City-based Aldwych Capital Partners.  

Industrial companies in Italy, for instance, have been blocked from tapping into traditional sources of capital, he said. Yet many of these European companies that cannot get traditional financing are “solvent, real and need money,” Wheeler said.

Italy and France are among the top five European countries — along with the United Kingdom, the Netherlands and Russia — logging the most new junk bond issues this year. Issues from the five countries have totalled $50.1 billion to date.

Italy and France are deemed riskier bets among the group. The French legal system, for example, isn’t very favourable to creditors, explained David Ennett, European high-yield bond fund manager at Edinburgh, Scotland-based Standard Life Investments.

“If you run into problems, your prospects for recovery are poor,” he said.

Even so, as a group, European junk bonds have stronger covenants than US bonds, which adds to their attractiveness.

“More and more better quality deals are getting refinanced,” said Ennett, “and they’re more rigorous.” 

European junk bond issues are also more likely to be secured, according Moody’s, though European investor protections have also weakened a bit this year. What’s more, risky bonds are only a small part of the European market.  Lower rated single B and triple C issuers make up just 31% of the European high yield market, compared to 61% for the US, said Ennett. Europe’s current low default rate of 2.9% is the same as the US’s, according to Moody’s.

Europe is also a highly liquid market for junk bond investors, so it is easy to buy and sell—and not get stuck holding bonds that might default.

“I’d be worried about liquidity anywhere else,” said Ennett, who expects a steady trickle of new European junk bond issues this year to attract more investors.