According to credit market analysts, the outflow reflects a new mood among fund managers, who are beginning to seek higher ground. Take Lewis Aubrey-Johnson, fixed-income product manager with Invesco UK Ltd. in London. While he is not totally abandoning non-investment grade, he says he is beginning to gradually upgrade the quality of his credit portfolio. "There have been sound reasons for high-yield to be priced as tightly as it has, but you have to start asking yourself whether it's right to be taking a lot of risk now," Aubrey-Johnson says.

Especially in higher risk environments, investor sentiment often plays as large a role as hard numbers. Deutsche Bank analysts in London recently issued an annual report that uses loss data to work out how much spread corporate bonds should provide to sufficiently offset the risk of default. As it has for the past several years, the research found that while the vast majority of investment-grade bonds offer enough spread to cover the risk to investors, high-yield bonds usually don't. An investor holding a single-B bond for one year, for example, would need a spread of 387 basis points (assuming average recovery rates). Investors in bonds rated Caa-C would need 1,674 basis points of spread to be adequately compensated for the risk of default over a single year. What's different this year is that the gap between what history suggests investors should be getting and what they actually are getting has been startling. Spreads have spent large amounts of time below the 300 level, and at one point in March dropped to a low of 243. Since then, spreads have climbed back up to around 310–still a long way below the levels needed to compensate for risk.

Gary Jenkins, one of the report's authors, says there are signs that the mood among investors is starting to turn. "We've released this report annually for the last seven years. But this year we saw a huge amount of interest. That could indicate that people are psychologically pulling back and getting ready to cut."

WHOSE DEFAULT IS IT ANYWAY?

How much has the risk of default actually increased? Experts differ on exactly how much credit risk high-yield investors will have to face this year. S&P expects an average default rate for the year of 2.2% based on a continued decline in risk over the coming months, followed by an uptick in defaults in the fourth quarter. Research issued by the agency at the start of March notes that "concerns [remain] for a more material increase in defaults in 2006 and beyond."

The forecast from Ed Altman, director of the credit and debt markets research program at New York University's Stern School of Business, is less positive. "The market seems to be expecting continued very low default rates for at least another two years. I think that default rates will actually grow to about 3% in 2005 and over 4% in 2006."

One factor that will have a bearing on overall default rates is the high volume of outstanding debt that falls into the riskier ratings categories. Not only have investors shown remarkable tolerance for low spreads, they've also allowed issuers to sell creaky structures. "The proportion of new high-yield issues rated B- or below reached an all-time high of 42.5% in 2004 after a relatively high 31% in 2003," says NYU's Altman. Fitch calculates that 2004 saw a year-on-year increase of 60% in the issuance of bonds rated triple-C or lower, with that segment accounting for fully 16.6% of the market's volume by year-end.

With that kind of volume, companies are going to have to hope that the market stays relatively committed to junk bonds. Otherwise, when bonds start to mature and companies start trying to issue new ones, they may find interest far harder to drum up, especially at the riskier end of the spectrum. That combo would certainly trigger a wave of defaults and a rapid retreat in liquidity.

So when does it all come tumbling down? "That's the sixty-four thousand dollar question," says Deutsche Bank's Jenkins. "The glib answer is that these conditions will last until defaults pick up or bond yields start to crack." But given increasing uncertainty, the word from credit analysts is that issuers should move forward with haste on any plans to come to market. Says Jenkins: "The combination of low yields, tight spreads and investor demand makes a compelling case for companies to move as soon as possible."