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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.

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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.

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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.

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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).

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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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