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.
“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.
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