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Junk Bond Strength Bodes Well For Stocks at Trader’s Narrative

Junk Bond Strength Bodes Well For Stocks

The insatiable appetite for fixed income investments has driven almost every piece of the bond market to new highs. The bellwether 30 year US treasury bond is trading at 133.44, close to its high of 142.66 in late 2008. Lower quality, ‘junk bonds’ are getting their fair share of attention too. As I noted last month, the average high-yield bond is now trading slightly above 100 cents on the dollar, something we hadn’t seen since June 2007.

There are two big reasons for the seemingly endless demand for bonds. The first is of course the Federal Reserve’s policy of prolonged zero interest rates. This is pushing everyone to reset their risk/yield parameters. The other is the US retail investor’s shift away from equity and into bonds. In the latest weekly mutual fund money flow data, US retail investors added another $7.8 billion to bond funds while withdrawing $5.6 billion from equities.

But while they eschew the risk inherent in equities, they clamour for yield to make up for the lost performance gap. Paradoxically, while junk bonds usually are considered a substitute for equities, the strength in junk bonds has historically corresponded with ensuing strength in the stock market itself.

high yield equity correlation Oct 2010

The above chart, courtesy of McClellan Financial, shows the performance of the S&P 500 index compared to a high yield bond fund, standing in as a proxy for the junk bond market in general. I’m not sure how to explain the relationship between the two asset classes. Perhaps this is a story about an increasing comfort with risk. Or perhaps it is about the availability of low cost cash to corporations which then turn around and use it to expand, buy back shares, etc.

The fact that junk bonds have managed to move above their April highs and sustain a uptrend (higher highs and a lower lows) looks promising for stocks that have yet to do the same.

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One Response to “Junk Bond Strength Bodes Well For Stocks”  

  1. 1 PEJ

    Difficult to interpret indeed. Maybe a longer time frame chart would help?

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