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Three of These Bonds Belong Together

Chad Karnes

In the 1970s the popular kids television show, Sesame Street, had a segment called "Three of These Things Belong Together".  The segment was based around a song with catchy lyrics saying, "Three of these things are kind of the same.  Can you guess which one of these doesn't belong here?"

The point of the segment was to help children develop their cognitive skills through observation, classification, and problem solving.

That segment has since been phased out of Sesame Street's programming, but the value of the underlying skills developed is one that should last a lifetime.

Three of These Things - The Grown Up Version

Sometimes the skills learned as a child are indeed the ones most useful to us as adults.  This is as true when it comes to the walking, talking, and eating abilities we learned as children as it is with the cognitive skills we also sharpened.

As a market strategist one of my jobs is to continually peruse the various markets in search of asset classes that offer opportunity.  This often includes finding and assets that are not behaving "normal".

AUDIO: Interview with Chad Karnes on the Index Investing Show

The chart below compares the iShares Treasury Bond 7-10 Year (IEF - News), the Market Vectors High-Yield Muni (HYD - News), the iShares S&P National AMT-free Muni Bond (MUB - News), and the SPDR Barclays High Yield Bond (JNK - News) performance year to date, presenting a similar setup as the outlier game we played as a child.

Three of these bonds belong together, and one of them indeed is not like the rest.

The chart above shows that when comparing the Treasury (TLT - News), Municipal, and Corporate bond categories, junk corporate debt is the only bond category that has gained in value this year.  Junk bonds are the outlier, not participating in the bond sell off thus far, and that raises some suspicion.

Rising bond yields are something we have been able to get ahead of.

In May, we were warning that a rising rate environment was around the corner, and our Technical Forecast readers were provided the analysis, charts, and trade alerts to take advantage of the trend change when we wrote:

"Continue to switch into shorter durations" and "shorter term bonds such as the iShares 1-3 year Treasury bond (SHY - News) or the Barclays 1-3 month T-bill (BIL - News) remain the safer place for your bond money".

That move saved Treasury owners over 9% as the longer durations saw large downside moves.

The rest of the bond market may be setting up something similar as corporate debt (LQD - News) won't be able to indefinitely evade the damage of rising yields.

What are the Implications?

Junk bonds have been the positive outlier this year when it comes to the bond market's performance, rising 5% YTD, and this raises red flags.  Why hasn't it joined other bond sectors like Treasuries and Municipals in a price decline?  Are corporations with lower creditworthiness immune to rising interest rates?

As discussed in our November ETF Profit Strategy Newsletter published 10/18, corporate bonds are now also underperforming compared to their historical relationship with the equity markets, and this could finally spell trouble for the high yield bond market.  Stocks have made new highs, yet junk bonds have only managed a double top.

Combining this underperfomance with the analysis outlined by our game above, we see this as a warning sign that corporate bonds will likely be the next bond shoe to drop, joining the other three debt classes in lower price, where it likely belongs.

Given that junk is the riskiest of corporate bonds, the adjustment back in line with its peers suggests a potentially swift 10% downside move as yield increases also hit the corporate bond sector.

The ETF Profit Strategy Newsletter keeps readers ahead of the market's trends.  Junk bonds have held their ground as the broader bond market sells off, but this outperformance is not expected to last as corporate bonds are starting to show some cracks in their uptrend.

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