One man’s junk bonds might be another man’s treasure.
Dramatic swings in the junk bond market often provide a valuable warning to investors. During times of turmoil, investors pile into ultra-safe U.S. government debt and rotate away from far riskier junk bonds.
That swing away from junk bonds often happens shortly before stock market downturns.
“High yield does provide useful sell signals to equity investors,” Barclays analysts concluded in a recent report.
Barclays combed through the past dozen years of data. The warning signal they found is a 30% or greater increase in the spread between Treasuries and junk bonds before a dip.
History is a guide: Consider 2002. The “spread,” or gap between the yields of junk bonds and Treasuries, spiked in July that summer after WorldCom defaulted on its debt and US Airways signaled it was filing for bankruptcy.
Investors who sold stocks based on the turbulence in the high-yield debt market would have escaped a 14% nosedive in the S&P 500 over the next 10 days.
“Had equity investors heeded the warning being sent from high yield, significant losses may have been avoided,” Barclays wrote.
While the stock market bounced back from that 2002 episode pretty quickly, the same can’t be said about when the sell signal was triggered five years later.
Junk bond spreads surged in June 2007 as two Bear Stearns hedge funds dropped a bomb on investors about massive losses in subprime mortgage assets.
Despite the alarm bells ringing in the credit markets, the S&P 500 set all-time highs as late as the fall of 2007. But then stocks began a long descent as it came to light that many more firms had similar subprime mortgage problems.
Many investors clearly wish they listened to that early warning from junk bonds.
Barclays said equity investors should “position defensively” the next time junk bonds start to go haywire. That doesn’t necessarily mean dumping stocks altogether. After all, the stock market eventually bounced back from each of the sell-offs Barclays examined.
Instead, lower volatility sectors like consumer staples and utilities could provide investors with cover during a potential storm. The analysis found that after the sell signal was triggered, these sectors outperformed higher-turbulence ones like materials and energy.
What is the signal now? Few people have been positioning defensively these days. Despite a tumble in the energy sector on Friday, the S&P 500 capped off a strong month of November during which it rallied 2.5%. Tech stocks did even better, driving the Nasdaq 3.5% higher.
So what are junk bonds saying about the stock market these days?
Just like the tumbling VIX volatility index, junk bonds are indicating “things have stabilized over the past few weeks,” said TD Ameritrade chief strategist JJ Kinahan.
“As we all know, that can change at any moment,” he said.