After an enormous rally in junk bonds in 2009 and 2010, Goldman Sachs, JPMorgan, Neuberger Berman, Guggenheim Partners, and Schroders Investment Management all recommend increased risk.

Meanwhile investor sentiment on US treasuries is at a record low and the bull-bear spread on equities has widened out to 36.3. According to Dave Rosenberg, that bull-bear spread is within striking distance of the 42.4 all-time high posted in October 2007.

Please consider Junk Spreads Narrow to 2007 Level on Fed’s QE2

The extra yield investors demand to own high-risk debt rather than government bonds has dropped 82 basis points this month to 540 basis points, or 5.4 percentage points, the lowest since Nov. 16, 2007, according to Bank of America Merrill Lynch’s U.S. High-Yield Master II index.

Goldman Sachs Group Inc. and JPMorgan Chase & Co. are advising clients to buy speculative-grade debt in 2011, even after gains of 14 percent this year and a record 57.5 percent in 2009.

“We’re going to start taking more risk as we go into next year because the economic fundamentals are better,” said Thomas O’Reilly, a managing director in Chicago at Neuberger Berman Fixed Income LLC, which oversees $11 billion in junk bonds.

Spreads on high-yield debt have tightened 187 basis points from this year’s high on June 11, according to Bank of America Merrill Lynch index data. The riskiest tier has narrowed the most this month, falling 122 basis points to 906, according to the bank’s US High Yield, CCC and Lower Rated index. Investment- grade bonds have dropped 13 basis points to 169.

“The sweet spot is high yield,” said Alberto Gallo, a credit strategist at Goldman Sachs in New York, which favors bonds with B ratings. “You want to gain as much spread exposure as possible, and you want to decrease your rate exposure, which is what you achieve with high yield.”

JPMorgan says investors should be “overweight” CCC ranked securities as the economy grows faster than expected, the New York-based bank’s Peter Acciavatti wrote Dec. 8 in a report. Overall, high-yield bonds will return 9.8 percent, he wrote.

“Certainly in my mind, QE2 is working,” said Scott Minerd, chief investment officer at Guggenheim Partners LLC in Santa Monica, California, where he oversees more than $100 billion. “As the availability of credit continues to increase as a result of monetary expansion, the prices of high yield relative to other assets should continue rising. And that makes high yield a safer place to be.”

Junk bonds should help shield investors from losses stemming from rising interest rates and inflation, said Lucette Yvernault, who helps oversee the equivalent of about 7 billion euros ($9.3 billion) as a money manager at Schroders Investment Management Ltd. in London.

Total return money managers, hedge funds and proprietary trading desks are all “eagerly” boosting their exposure to credit risk across asset classes, Ken Hackel, head of securitized product strategy at CRT Capital Group LLC in Stamford, Connecticut, wrote in a Dec. 15 note.

The U.S. default rate for junk-rated debt is expected to drop to 2.2 percent by this time next year, from 3.6 percent in October, Moody’s said in a report.

High-yield bonds will return about 7 percent to 12 percent in 2011 as defaults are “near zero” for the next few years, said O’Reilly of Neuberger, which in the past 13 years has owned one security that defaulted.

Guggenheim’s Minerd is adding junk bonds, focusing on those with B ratings in the 7- to 10-year range that yield more than 10 percent, and shorter-term notes that pay at least 6 percent.

“The forward momentum in the economy is very strong,” Minerd said. “We expect that next year will be one of the best for the economy that we’ve seen over the past 10 years.”

That is about as lopsided sentiment ever gets. The time to buy asset classes is when everyone hates them, not when everyone loves them. Nonetheless, extreme sentiment is only an indicator of extreme risk (or opportunity), not a timing mechanism.

The Inside Bet

Meanwhile corporate insiders (those most likely to actually know something), are bailing stock at a near record pace as Mark Hulbert explains in The Inside Bet.

Vickers Weekly Insider Report is a service that analyzes the insider data, calculating each week a ratio of the number of shares that insiders have sold that week to the number that they have bought. Over the last four decades, according to Vickers, this ratio has averaged between 2 and 2.5 to 1. As a result, the firm considers any reading above 2.5-to-1 to be bearish, since it indicates an above-average pace of selling on the part of insiders.

You better be sitting down before reading what this sell-to-buy ratio was this past week: 7.07-to-1. In other words, corporate insiders on balance are selling more than seven shares for every one that they are buying.

The last time this ratio was this high was the week ending Feb. 14, 2007, almost four years ago.

Does this mean the market will immediately tank? Of course not.

In fact, Jonathan Moreland, editor of the Insider Insights advisory service, advises clients to not prematurely give up on the rally, despite the worrisome recent trend of insider behavior: “Experience has taught us that it is usually best to stay the course until the indices themselves begin to show a change in trend. There is still good money to be made staying long in the late stages of a rally.”

Therefore, Moreland concludes, even as he remains on “high alert for a trend change,” for the moment he will continue to be fully invested.

David Coleman, editor of the Vickers Weekly Insider Report, is not willing to give the rally the benefit of the doubt that Moreland is willing to do. His two model portfolios currently have an average of about 60% allocated to cash, and in addition, one is hedged with a put option on the S&P; 500 index

Insider sales, together with extremely bullish equity and junk bond sentiment, and extremely bearish treasury sentiment, along with numerous technical divergences in the stock market, sounds one of the biggest warning bells in history.

Mike “Mish” Shedlock
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