INVESTORS’ memories are notoriously short, so when Standard & Poor’s (S&P) recently warned that they were getting even shorter, it was something of a wake-up call.<br /><br />Despite one of the biggest financial meltdowns and dislocations of credit in history, European investors are once again being seduced by the high yields on offer with junk bonds. These non-investment grade bonds are either rated BB or lower by S&P.<br /><br />Junk-rated European firms such as ITV have issued bonds worth €20bn so far this year and high yield bonds have returned 52 per cent year-to-date, well above the previous record of 39 per cent set in 1991.<br /><br />But to put this into context, says Vanshree Verma, fixed income strategist at Barclays Wealth, credit sold off to unprecedented lows last year. This meant high yield bonds ­– like many other risky asset classes – had a horrible 2008. For example, Barclays Capital’s US high yield index saw total returns of -26 per cent in 2008.<br /><br />All of this is true – but it is also the case that liquidity fuelled European investors are piling into high-yielding junk bonds, a market which now looks very much as if it were in the grip of a nasty bubble. <br /><br />One driver has been the mass purchasing of government and investment grade corporate debt by central banks in both the US and the UK, which has depressed yields on these safer bonds, making them less attractive to buyers.<br /><br />Equally supportive of investors bidding up junk bonds has been the anticipation that corporate defaults will soon peak as the economy moves into recovery mode. The spreads of high-yield bonds over Treasuries have fallen to around 700 basis points. At the height of the credit crunch, the excess return over Treasuries demanded by investors for high-yielding junk bonds reached 19 per cent. <br /><br />Spreads are now back to pre-Lehman levels (at a time when they were of course too low) thanks to the huge fiscal and monetary stimulus. This has reduced investors’ fears about the future and made speculative bonds more attractive and, superficially at least, less volatile. Investors have also been choosing speculative bonds because of the lack of returns on offer in the money markets and in investment grade bonds. <br /><br />Verma says that investors still attracted to the high returns offered by non-investment grade bonds should be more concerned about credit selection within the high-yield bonds on offer. <br /><br />“Default-rates remain a concern but the levels of spreads seem to have largely priced this in. Investors in our opinion need to select junk bonds with sound credit fundamentals and keep track of valuations,” she adds.<br /><br />Junk bonds might not be yielding junk any more, but investors will need to cherry pick if they are to avoid being wiped away when quantitative easing stops, yields jumps and the bubble pops.