Heed the Warning Signs From High-Yield Bonds

High-yield bonds can be indicative of what's to come for stock markets

The stock markets are around half the size of the bond markets. Estimates for the U.S. bond market put it around $40 trillion with the global bond market over $90 trillion. Therefore, the bond market is  generally considered “smarter” than the stock market — one of the reasons being the mere size of the bond market.

Regardless of the differences, there are also some similarities between bond and stock markets, especially when it comes to certain kinds of debt.

High-Yield Bonds

The high-yield bond market, as tracked by the SPDR Barclays Capital High Yield Bond ETF (JNK), is the closest behaving market to stocks.

The similarity is mainly due to the fact that higher yielding debt is typically the last piece of debt that gets paid from earnings.  The collateralized and safer debt tranches usually take priority.  Plus, bond interest payments are always paid before dividends. Therefore, bonds are attractive investments and are typically less volatile, more reliable than stocks.

High-yield bonds (also known as junk) behave very similarly to their respective stocks from a price movement perspective, which is why many investors like to follow the junk bond market, as tracked by the iShares iBoxx $ High Yid Corp Bond ETF (HYG) for signals that may eventually affect stocks.

Junk bonds can often be the proverbial canary in the coal mine.  If there are going to be any disturbances going on behind the scenes, the bond market will likely sniff it out before the stock markets do.  After all, if the smarter, safer and less volatile high-yield bond market is misbehaving, then the more volatile and less “smart” stocks will soon follow.

Junk Versus Stock

Check out the chart below showing JNK along with the S&P 500, as tracked by the SPDR S&P 500 ETF Trust (SPY).  Generally, the two markets are very correlated — as shown in the bottom section of the graph — meaning they move in similar directions most of the time. The correlation is a testament to their similar characteristics, but recently, something has happened as the dip in correlation alludes to.

JNK short term

Notice that JNK (the colored line) has not made new highs and is close to making new lows below its July levels? Those lows are synonymous to the S&P 500 falling below 1900, around 4% lower.

More specifically, JNK has double-topped with its June and August highs as its price continued to fall on Thursday and is now breaking below its 200-day moving average at $40.25.  Even though the stock markets saw huge rebounds on Wednesday, Sept. 24, the high-yield bond market did not confirm that bounce as it finished down on the same day, warning that the bounce in stocks likely would not stick.  Sure enough, the following day, Thursday, Sept. 25, saw the downtrend resume with major selloffs in all markets.

In May 2013, a similar early breakdown in high-yield bonds, as tracked by the Blackrock Corporate High Yield Fund Inc ETF (HYT), which also helped warn of that continued decline in stocks into June 2013.

If JNK falls below its July low at $40, I think it offers investors an opportunity to short as the weakness in high-yield debt, as tracked by the ProShares Trust ETF (SJB) would suggest that all is not well for stocks.

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