Junk science: High-yield bonds hold key for stocks

August 6, 2014 12:16 PM

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Junk science: High-yield bonds hold key for stocks

If restricted to only one indicator to handicap the stock market, one could hardly do better than this picture of the high-yield bond market. It shows the spread between junk-bond index yields and 10-year Treasury yields, and it captures most of the key drivers of financial markets: the pull of low yields, willingness to embrace risk, the outlook on corporate profits and liquidity conditions.

Note the long decline since the panic environment of 2009, coinciding with the S&P 500’s 180% surge - interrupted by the Euro debt crisis in 2011, which produced a near-20% U.S. stock-market drop.

Since dropping to near-record lows in late 2013, junk spreads have twice spurted higher - in January-February and in the last six weeks or so. In both cases stocks quickly skidded a bit. So far, the S&P 500 remains well above where it was in the winter when spreads around current levels. There’s not a linear relationship between these to markets, but for context it shows that the stock market had run a good bit ahead of high yield since the spring.

If yield spreads settle down, it should allow for stocks to stabilize, given that absolute junk yields remain below 6% and few signs of credit risk are at hand. But if high yield continues to weaken, exacerbating choppy capital-market conditions elsewhere, it will suggest that a more important mood shift is underway and the late-summer stock-market wooziness won’t quickly pass.

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