The Tell: Why ‘junk bond’ resilience offers comfort to stock market bulls

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The $1.3 trillion high-yield bond market, which often tracks performance in stocks, hasn’t shown signs of cracking and that has offered a degree of solace to Wall Street investors.

According to Martin Fridson, chief investment officer of Lehmann Livian Fridson Advisors, investors may have been confounded by the high-yield sector’s resilience despite an equity rout that pushed the Nasdaq Composite Index COMP, +2.00% into correction territory, characterized by many as a decline of at least 10% from a recent peak.

High-yield corporate debt, or junk bonds as they are often referred, have a reputation as a canary in the coal mine for the stock market because they are closely tied to the strength of the U.S. economy similar to equity markets.

Fridson, a prominent fixture in the high-yield market, said some investors could interpret the absence of a major selloff in so-called junk bonds in tandem with the Nasdaq, S&P 500 index SPX, +1.08% and the Dow Jones Industrial Average DJIA, +0.97%  as a suggestion that a retrenchment in stocks may have more to do with worries about heady valuations among the biggest and most influential participants in the market’s recent run-up to fresh highs and its test of new lows—including Facebook Inc. FB, +3.95% Netflix Inc. NFLX, +5.63% and Amazon.com Inc. AMZN, +4.51% —than concerns around the health of U.S. economy and the belief that corporate earnings won’t get much better in the future.

See: This recession indicator shows investors have faith U.S. growth has room to run

“There may be encouraging news in the fact that high-yield did not lead equities in the recent selloff. Perhaps the high-yield market did not pick up recessionary vibes sooner than the stock market did because there were no such vibes,” said Fridson.

In October, the S&P 500 sank by about 6% and the Dow gave up about 5% (Both major benchmarks looked set to log their best two days gains since February of 2016).

Meanwhile, over the past month, the SPDR Bloomberg Barclays High Yield Bond exchange-traded fund JNK, +0.13% and the iShares iBoxx $ High Yield Corporate Bond HYG, +0.02% popular funds used to wager on the junk-bond market, around 2%, a more muted decline by comparison, FactSet data show.

The yield for the benchmark ICE BofAML U.S. High Yield Master II index has risen around 0.60 percentage point to 6.83% in October. The index’s yield spread relative to risk-free Treasurys has also widened by more than 0.60 percentage point to 3.89 percentage points. Bond prices move in the opposite direction of yields, while a widening spread reflects how investors are demanding more of a yield premium in line with their growing perception of risk.

It is true stocks and junk bonds do often move in tandem, reflecting their shared status as a risk asset. Fridson’s calculations high-yield bond prices sport a positive correlation of 0.59 with the S&P 500 SPX, +1.08% and a negative correlation of 0.02. A correlation of 1 means the assets move perfectly in sync, while a correlation of negative 1 means they move in opposite directions.

Analysts attribute their close relationship to the way stocks and bonds sit in the ladder of financial obligations for a corporation. In the event of a default, bondholders are paid out before equity investors. Therefore, a perceived rise of growing default risk endangers the pool of company assets left over for equity investors, the residual claimants, last in line if only because they’re amply rewarded with a claim on a company’s profits, instead.

“Within this intellectual framework, there is no way for the bonds to rise while the stocks fall or vice versa,” said Fridson.

That is why high-yield bond spreads have historically tracked the stock market’s implied volatility gauge, or the Cboe Volatility Index. VIX, -9.46% which tends to move inversely to stock prices, rising as they fall.

However, Fridson says there’s sufficient reason for equities and high-yield to fall apart at some point. He highlights a lack of fresh supply of sub-investment-grade debt, which could have depressed the value of existing junk debt and driven yields higher.

Analysts at Bank of America Merrill Lynch forecasts U.S. sub-investment grade issuers to sell $205 billion of bonds this year, 25% below the $270 billion last year.

But for now, high-yield appears to be in solid shape and that is likely good news for stock investors—for now, Fridson and other experts say.

Read: Junk bonds became a ‘quiet haven’ for investors, says BAML

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