Are Junk Bonds Sending a Warning Signal?

Over the past month, we have seen a rip-roaring, v-shaped rally to new all-time highs in the large-cap U.S. equity indices. At the same time, volatility has been crushed in a move lower in the VIX Index that we have never seen before (above 30 to below 15 in the span of 2 weeks). The combination of these two factors has left individual investors feeling extremely optimistic about the future prospect for equities. There’s nothing investors love more than a straight up move with low volatility.

junk1

While this level of optimism is generally problematic on its own, there is another interesting factor at play here.  We are not seeing nearly the same level of risk-seeking behavior in the riskier areas of the credit market. This is atypical as junk bonds are normally highly correlated with equities and we would expect credit spreads to be hitting new lows here. Quite the opposite has occurred. High Yield credit spreads bottomed back in June at 335 basis points. They stand today at 446 basis points, higher than their levels from one year ago.

junk2

As the bond market is often a leading indicator of equities, this may be a warning signal. For if investors are demanding a higher spread in the riskiest areas of the credit market, they are becoming increasingly concerned about the economic environment and potential default risk. Naturally, if this persists, it is only a matter of time before they also become concerned about the lowest part of the capital structure: common equity.

This weakness in high yield is a new development in the market, for as can be seen in the chart below the credit market environment had been extremely benign since late 2012. Only recently have spreads turned higher on a year-over-year basis.

Junk3

If we look back historically, volatility in stocks is much higher (25% annualized) when credit spreads are up year-over-year as compared to when they are down (13% annualized).

Junk4

Higher volatility is of course something few investors are considering here with the VIX at 13 and promises of continued central bank easing seem to arrive on a daily basis. However, as Charles H. Dow said back in 1900, “the one fact pertaining to all conditions is that they will change.” Conditions are clearly changing here in the credit markets. How long will it be before the equity market takes notice?

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Edward M. Dempsey Pension Partners New YorkCharlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of two award-winning research papers in 2014 on Intermarket Analysis and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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ATAC Week in Review: Fear Lower Oil

“Never be afraid to sit a while and think.” – Lorraine Hansberry

Large-cap stocks held on to moderate gains as the average stock was flat to down in a week that on the surface looked uneventful, but from a sector standpoint had important movements take place.  The Utilities sector, perhaps the most predictive sector of the stock market, broke down meaningfully relative to the broader stock market starting Wednesday.  At first glance, one might think after reading the 2014 Dow Award paper on Utilities (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2417974) that this is inherently bullish for stocks given that when the Utilities sector underperforms, historically going back to 1926 stock market volatility drops and equities rally.

And while this is true, the issue is the speed of underperformance.  The faster Utilities underperform, the more likely on a short-term rolling basis in the coming weeks they are to outperform as that lower relative level dictates the soon to come change in rate of change.  This means that while Utilities breaking down is bullish, the speed may actually be a set up for another pulse of risk-off strength, potentially at the tail end of November for another trigger to get defensive through either an all-in rotation to defensive sectors away from cyclicals (as our equity beta rotation strategy does), or an all-in rotation out of equities into Treasuries (as our inflation rotation strategy does).

We are only a few short weeks after the end of Quantitative Easing, and Wall Street seems to be under the impression the year is over, forgetting that the last time QE1 and QE2 ended, stocks corrected severely a month later.  That would imply December may actually be a high risk month.  Ten-year Treasuries, which have held in a tight range just above 2.3% are still signaling concern about US growth and inflation, as yields still seem to ignore what tends to be negative seasonality for Treasuries that begins in November.  Combined with Junk debt taking another relative hit, the precursors to a meaningful breakdown seem to be taking place potentially as credit spreads widen and fail to confirm overall bullish sentiment into year-end.

In Arkansas last week, I did a presentation on our award winning papers, and someone in the audience was joking sarcastically with a prior speaker that lower Oil is deflationary, making fun of the idea that saving money is bearish.  When I got up, before beginning, I addressed his point quickly and said “be careful what you wish for” when it comes to lower Oil.  The meme out there is that lower Oil is bullish, but that completely disregards the speed with which Oil breaks down.  Historically, meaningful declines in equities have been preceded by Oil breakdowns.  Furthermore, the faster Oil breaks, the more likely highly leveraged shale producers go bust.  Popular junk debt ETFs and indicies have Oil and Gas as the heaviest sector overweight within those averages.  Collapsing Oil could set off a deflationary butterfly effect whereby spreads widen and filter through to all corporates, which in turn would be a form of credit tightening forced by the market as opposed to the Fed.

For us, we believe the post QE3 environment is extremely positive for the types of aggressively defensive rotations both of our main strategies (one alternative, one equity) do when conditions favor based on proven historical indicators a coming regime changes in stock market volatility.  The challenge since QE3 began for us all along has been that the Fed steamrolled any kind of a “risk trigger,” causing any warning signs of volatility changes to be ignored by markets.  With that distorting factor out of the way, it stands to reason volatility and correlations revert to historical cause and effect.

Sincerely,
Michael A. Gayed, CFA
Chief Investment Strategist
Pension Partners, LLC
Twitter: @pensionpartners
YouTube: www.youtube.com/pensionpartners

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

 

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