Investors pulled a record $7.1 billion from junk bond funds in the second week of August, according to the Lipper U.S. Fund Flows report. The massive outflows — which are the biggest since Lipper records began in 1992 — also included the largest exodus from stock funds and U.S. stock ETFs since February.

Paired together, this is a signal that investors are beginning to step away from risk assets.

But is this just an overdue correction for high-yield bonds, and therefore a short-term head-fake that turns into another buy-on-the-dip episode?

Or could it be foreboding a broader downturn that extends into stocks in the near future?

Short-Term Correction or Canary in the Coal Mine?

In the camp of the head-fake theory, this pullback in junk bond funds is not surprising, considering recent high valuations for high-yield bonds and increasing anticipation of higher interest rates on the horizon. An extremely low-interest-rate environment sent fixed-income investors looking for higher yields, and appetites for risk also were higher when the Fed was more accommodating.

To paraphrase Mark Twain, history does not repeat itself … but it does rhyme.

The big-picture concern that still remains is that junk bond corrections have led to stock market corrections in the past. As Barron’s reported in July, junk bonds have been extremely overvalued for nine consecutive months, which just surpassed the eight-month streak of overvaluation from October 2006 to May 2007, which was followed by a similar correction. The stock market peaked five months after this correction, which started one of the worst bear markets in history.

Could there be a “rhyme” in 2014?

Junk Bond Outflows – Opportunity and Caution

As with any other buy or sell decision, your risk tolerance and investment objectives should be the top factors. There is no doubt that junk bond funds are not the best fixed-income choice for your portfolio if you are concerned that a new bear market is imminent, especially if they’re your only exposure to the bond market.

As I cautioned in my recent story on the best junk bond funds, high-yield funds definitely deserve a “buyer beware” warning because, although they can bring stock-like gains, they also can produce stock-like declines.

For example, one of the funds I reviewed in the story, Loomis Sayles High Income Opportunities (LSIOX), had a return of -28.5% in 2008, but in 2009 it jumped back 60.3%.

The manager of LSIOX and the vice-chairman of Loomis, Sayles & Comany is the legendary Dan Fuss, who has 50 years of experience in the complex world of fixed income. As reported by Reuters, Mr. Fuss said of the record junk bond outflows this month:

“The junk bond market is the very market that went up farther than others, so this isn’t too surprising. The market is now for sale, but we are still watching the high-yield market and will be adding opportunistically.”

Bottom Line

A final word of caution, balanced with opportunity: Investors with time horizons of less than three years should generally avoid or minimize exposure to riskier assets, such as junk bond funds and stock funds, no matter what the market or economic environment.

However, junk bond funds still can be a wise part of the fixed-income portion of a long-term investor’s portfolio.

As of this writing, Kent Thune did not hold a position in any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.