The sun may be setting on high yield bonds, cautions George Putnam, an expert in distressed debt and the editor of The Turnaround Letter.

As the coronavirus outbreak threatens the record-long economic expansion, and potentially the record-long bull market in stocks, we thought it would be valuable to turnaround investors to comment on the state of the high yield bond market.

These bonds carry more sensitivity to economic conditions than those with investment-grade credit ratings, as their underlying companies generally need a healthy economy to service their heavier debt burdens.

Over the past ten years, through January, the performance of high yield bonds reflects their position between equities and investment-grade bonds. The bonds’ 7.9% annualized rate of return is above the 5.3% rate of higher-quality bonds but below the more cyclical 14.0% rate for the S&P500.

Comparable maturity U.S. Treasuries have produced a more humble but still generous (for a risk-free instrument) 4.1% rate of return. Historically, these decade-long returns are impressively high.

Investors are well-aware of the driving forces behind these gains: healthy economic growth, supported by chronically low inflation and central banks’ strenuous efforts to reduce interest rates.

With yields now reaching record lows, and credit defaults docile, yield-oriented investors can hardly be blamed for scrambling into high yield bonds as a seemingly low-risk way to capture higher income.

With investors voracious appetite for yield, Wall Street has been more than happy to supply the market with higher-yielding bonds. Last year, $266 billion of high yield bonds were issued, continuing a decade-long trend of heavy new supply.

Along with this craving for yield, investors have swallowed bonds with very weak covenant protections, which otherwise would provide better recovery rates in a default. Not only have public debt markets provided generous high yield financing, but a rapidly growing private credit market has emerged, now almost $800 billion in size.

Along with their private equity brethren, these lenders provide funds directly to corporate borrowers, typically for acquisitions. Private acquisition markets reflect the aggressive inflow of funds, with average deal prices approaching a highly elevated 12x EBITDA.

A large proportion of these deals carry leverage above 6x adjusted EBITDA, with the adjustments becoming ever more generous, including cost-savings that have not yet materialized. The high valuations and high leverage have put investors at risk of higher default rates. By some estimates, default rates in a recession can approach 30%.

At their best, most bonds can only provide investors with the principal balance at maturity plus the interim interest payments. With high prices, low yields and limited credit protection, high yield bonds almost appear to be a one-way bet currently: if you succeed you will get your money back.

If you’re wrong, you will lose potentially large chunks of your capital. Historically speaking, conditions are likely to go in only one direction: worse. For turnaround investors looking at high yield bonds, this is a time to be cautious. Companies with credible business plans and reasonably good prospects may have appealing bonds.

But, in general, the high yield sector looks unlikely to continue its strong performance and now carries increased risk. Investors should wait for the cycle to turn downward, then look for bargain prices in distressed bonds and newly emerged post-bankruptcy stocks.