As strategists study the recent bout of stock market turbulence, they are paying close attention to the high-yield bond market – and wondering if it is signalling an oncoming correction.
These bonds are issued by companies with less-than-stellar credit ratings. They have been wildly popular among investors as the U.S. economy improves and corporate default rates decline, making high yield bonds look awfully compelling in a low-yield world.
But something interesting has happening over the past few months: High-yield bond prices have been stumbling since June, sending yields higher, especially in relation to rock-solid U.S. Treasury bonds.
Andrew Garthwaite, global equity strategist at Credit Suisse, pointed out that the spread between high-yield bonds and U.S. Treasuries has widened by 108 basis points (or 1.08 percentage points) since June – closing in on 115 basis points, which is the average spread that serves as a warning signal for stocks.
Indeed, a spread this wide historically has preceded an equity market correction of 10 per cent or more, typically leading the selloff by about three months.
"Taking history as a guide, therefore, high-yield spread widening is becoming worrisome," Mr. Garthwaite said in a note.
Should you be worried?
Three months after the spread began to rise, stocks are indeed wobbling. Globally, stocks suffered their worst quarterly setback since 2012, according to Bloomberg News.
The S&P 500 fell 31 points in September, or more than 1.5 per cent, for its worst one-month performance since January.
Perhaps more worrisome, the U.S. benchmark index hasn't suffered a correction in three years, making it appear long-overdue for a significant setback.
However, Mr. Garthwaite has taken an upbeat view on where high-yield bonds go from here: He thinks an ongoing selloff is unlikely, for a number of reasons.
First, at their low point in June, high-yield spreads did not reflect the default rate forecast from Moody's Investors Service; the spread was too low. Now, though, the higher spread is consistent with the default forecast, meaning that bonds are priced more appropriately for the risk.
Second, derivative spreads in the United States and Europe haven't widened to the same extent as so-called cash spreads.
"We find this encouraging," he said. "One interpretation of this could be that the professional investors are less concerned than retail investors."
Third, the selloff isn't global. While U.S. spreads have widened by 108 basis points, comparable European spreads have widened by just 84 basis points.
Fourth, investors aren't fleeing high-yield bond funds any more. Following significant outflows earlier in the third quarter, money has been flowing into U.S. high-yield exchange-traded funds in recent weeks.
And fifth, the European Central Bank and the Bank of Japan are adjusting their inflation expectations downward while expanding their balance sheets. That should offset concerns over the end of the Federal Reserve's bond-buying program – slated to wrap up later in October – which could be weighing on the bond market.
If Mr. Garthwaite is right that the worst of the selloff is over, then high-yield bonds look compelling now.
The SPDR Barclays High Yield Bond ETF has fallen 4.1 per cent since June, and has an indicated yield of 5.6 per cent. The iShares iBoxx High Yield Corporate Bond ETF has fallen 3.9 per cent since June, with the same indicated yield.
As for how higher yields will affect stocks, Mr. Garthwaite has a few thoughts at the sector level.
If U.S. economic growth is stronger than expected, telecom stocks and utilities will suffer the most, given their hefty debt levels and relatively low operating earnings. Conversely, technology stocks with typically low debt levels and high operating earnings will benefit.
But the bigger issue is where the broader stock market goes from here. If high-yield bonds aren't signalling a correction just yet, they are providing a good reason to be careful.
David Berman