The high yield market has been an active participant in the recent back-to-normalcy trend, also called “reinflation”, where asset prices revert back to familiar, pre-financial Armageddon levels (though not bubble-era levels). The high yield market can serve as a measure of investor risk appetite since it is one of the riskiest asset classes during a credit bust. This is reflected in the steep discounts high yield bonds traded at during 4Q 2008 and 1Q 2009. Buying high-yield bonds two months ago would easily have provided a 30% return.
This rally coincides with a tremendous increase in supply. New issuance last week alone was $5bn. The total for April and May was $10bn and $25bn, respectively. These are huge numbers considering that from July 08 to March 09 there were only $2.2bn new issues a month ($20bn total). This supply has been met with 12 straight weeks of a positive retail funds flow totaling $8.12bn. This sustained flow into junk bonds underscores investors’ new risk appetite.
This is also evident in the tightening of spreads between all high yield credit and high yield utilities. Since traditionally utilities are seen as a low-risk sector, they can be used to measure risk appetite in a manner similar to treasuries. High risk appetite during the credit bubble tightened spreads between treasuries and corporate bonds. Likewise, rising risk appetite is now tightening spreads between high yield credit and high yield utilities. 
The question is, how long can this rally continue? There has been a lot of optimism in the high-yield market, as debt for many highly leveraged companies went from trading at 40 cents on the dollar to 70 cents on the dollar. These gains obviously can’t continue for long. As you can see in the chart below, yields are now around the level they were during the 2001-2003 recession, which was much milder, especially for credit markets. The default rate this year is expected to be 13.6%. The highest default rate during the early 2000s recession was 12.8%. The expected default rate for leveraged loans is 9.0% for 2009, which in the early 2000s reached a peak of only 6.6%.
I would argue the tightening of the spread between high yield utilities and other high yield credit indicates a leveling out of risk appetite and, therefore, yields. We can expect the high yield market to move like other asset classes that have hit their reinflation zenith (like US equities)—sideways.
