Wall Street Week Ahead: Want to Get Back Into Stocks? Check Junk Spreads First

New York: A positive vibe returned to the US stock market Friday, leaving some to wonder if, after two weeks of losses, the latest selloff scare was over. The best clues may come from what happens to low-quality corporate bonds.

The most recent decline in the S&P 500 marks the third time in six months that the market has looked wobbly and threatened a significant reversal. Each time, so far, it has bounced back quickly.

But what has some investors most worried this time around is the recent, notable underperformance in junk bonds in the past few months. In the past this has been a precursor to bearishness in the equity market.

High-yield corporate bond spreads, the premium investors get for purchasing low quality corporate debt as opposed to benchmark US Treasuries, have been increasing steadily since late June. A widening spread means their performance is lagging higher-quality bonds.

The spread has since widened by more than 100 basis points, according to Bank of America-Merrill Lynch data. Previous spikes of this magnitude have preceded pullbacks in the S&P 500, and the greater the selloff in high-yield debt, the worse the outcome was for stocks.

"Spreads are widening and it's certainly not a good time for equities. It doesn't have to be a terrible time, but it's telling you people are on the margin taking risk off," said Paul Zemsky, chief investment officer of Multi-Asset Strategies and Solutions at Voya Investment Management in New York.

He said that while reduced liquidity in the high-yield bond market could exaggerate the moves in spreads, the overall signal is of a marked shift in sentiment.

"I do think (the spread) has some information in terms of risk appetite and how people see economic growth," Zemsky said.

High yield most recently started widening against Treasuries beginning on June 23, when the S&P 500 was around 1,960, with the peak set earlier this week at an increase of 116 basis points. The S&P closed the week at 1,967.90 while the yield spread tightened slightly to 107 basis points.

The last time such a shift in spreads started was in May 2013, and it preceded a near 6 per cent fall in the S&P. Weakening in junk bonds in early 2012 also preceded an S&P downdraft between April and June 2012, when the S&P last flirted with a 10 per cent drop.

However, the move may not yet signal a market correction. As has been the pattern in 2014, investors are content to move money between different stock market sectors rather than flee altogether. Small-cap shares entered a correction at one point this week and the S&P energy sector fell 13 per cent from their 2014 peak, but investors piled into the healthcare sector, which hit a lifetime record early last week.

In April 2011, high yield spreads began widening in a move that eventually reached 450 basis points. Stocks didn't begin to correct until the spread had moved nearly 100 basis points, but eventually they sank nearly 20 per cent.

"If you run a chart of junk spreads going back five years this move is tiny. We've seen much, much bigger moves in junk, and much bigger selloffs in junk in the last five years," said Brian Reynolds, chief market strategist at Rosenblatt Securities in New York.

The current spike, he said, "did predict (the move) in stocks, it did follow through and we're probably now reaching a climax of panic," he said.

This is why the next move in credit spreads becomes key. Next week is relatively light for economic data. Investors haven't run entirely from bond markets, but have shifted funds around. High yield funds saw an outflow of $2.3 billion in the most recent week to October 1, the most since early August, according to Lipper, as they moved money into high-grade corporate debt.

The focus may shift again to escalating conflicts in the Middle East, the stubborn weakness of the European economy, or the outcome of Hong Kong pro-democracy protests that are challenging the authority of Beijing.

For Brian Jacobsen, chief portfolio strategist at Wells Fargo Funds Management in Menomonee Falls, Wisconsin, the key lies in earnings reports, which begin in two weeks.

"If we don't get earnings corroborating the (bearish) story being told by spreads, then I think we'll see the spreads come in."

Copyright: Thomson Reuters 2014