It's not reflation; it’s risk-taking. But we are approaching the end of it.

Confirming our risk-taking thesis is the fact that junk bonds' value continues to rise while investment-grade corporate bonds have been falling since the beginning of the year. According to Bloomberg Barclays Indexes, while USD investment-grade bonds fell by -3.22% year to date, USD junk bonds rose by 1.16%. The reason for this trend is not entirely speculative. Indeed junk is the only asset providing a yield high enough to allow investors to protect against rising interest rates as well as inflation. In the context of a diversified portfolio, junk bonds can prove to be essential instruments because they are able to contribute to exciting yields while limiting duration. It easily explains why junk bonds demand remains sustained while their spread continues to tighten. To put things into perspective, it helps to know that the average yield offered by investment-grade bonds in the US at the moment is 1.9%, while the 10-year Breakeven rate is around 2.17%. It means that if you buy into investment-grade bonds, you will lose all your return to inflation. It is necessary to take an average duration of around 15 years to find a yield above 2.5% within investment-grade corporate bonds. Instead, an investor can secure the same yield in the junk bond space by bearing an average duration of 4 years. The difference is immense, especially when interest rates are rising and getting exposure to long-duration would make one portfolio more sensitive to interest rates changes.

Therefore, it is explained why junk prices are supported while triple C-rated corporates in the US provide an average yield of 6.23%, the lowest in history.  It doesn't change the fact that sooner or later, a repricing within this space is doomed to happen, especially when US Corporates' leverage is the highest level in almost 20 years. It means that not only junk is expensive, it is also the riskiest in two decades!

Yet, investors are not worried about it now, and the bifurcation between junk and high grade becomes more prominent every day.

The higher US Treasury yields will rise, the more significant a selloff of risky assets will be. However, how much yields need to increase to provoke a selloff within junk?

The chart below tells us that something might have just started to change within the junk space. The correlation between the Bloomberg Barclays USD High Yield Total Return Index and Treasury yields in the past ten years has been positive. However, from the chart below, it is possible to see that the correlation between yields and junk bonds returns becomes negative when yields accelerate upwards. This has been particularly true during the 2013 "Taper Tantrum" and the 2016 US Elections. The graph below shows that the correlation between the two might have just turned negative, signalling that investors might just be starting to dump these assets. Hence, a selloff in junk bonds becomes inevitable in light of rising interest rates. 

Unfortunately for junk bondholders, yields look very likely to run hot for some time. Historically, as the chart below shows, commodities have lead yields by almost a year. At the moment, we are seeing commodities rising fast, but, have they reached a peak? Whenever we see commodities peaking, we can expect yields to peak around 10 to 12 months later. Thus, the current rise in yields might just be the beginning of a much deeper selloff that would see 10-year yields rise above 2%.

The market now focuses on 10-year Treasury yields trying resistance at 1.5%, but where can they go from there? Looking at the chart below, it looks like 10-year yields are on the way to 2%. Once the strong resistance level at 1.5% is broken, yields will trade in a consolidation area between 1.5% and 1.65%. Once they break above 1.65%, they will finally accelerate to try the new resistance at 2%.