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Friday, April 12, 2024

Junk vs. Investment Grade Bonds, What Does the Divergence Suggest for Equities?

Junk vs. Investment Grade Bonds, What Does the Divergence Suggest for Equities?

Courtesy of Mish 

Businessman getting knives thrown at him

Minyan Harvey is inquiring about the divergence between junk bonds as measured by JNK and higher grade corporates as measured by LQD.

The question is in regards to Corporate Bonds Smacked, Junk Yields Rise, Deals Pulled; Treasuries Rally; Yield Curve Flattens; Global Slowdown Coming

Minyan Harvey writes …

Prof. Shedlock (or is it Prof. Mish),

Hope you are well. Just read your post in Buzz & Banter about JNK in particular and high yield corps in general. I see all of that and it confirmed what I thought the junk market was telling us. However, one thing confuses the heck out of me, and I hope you can clear this up. Why is the investment-grade market (LQD) seemingly holding up so well? In 2008, the LQD fell throughout the year and slightly led the equity market down in the waterfall decline. Yet LQD is actually HIGHER year-to-date and up ever so slightly since the April top in equities.

What gives? If we are headed for another 2008 waterfall, shouldn’t the LQD be showing signs of stress?

I defer to you as I am anything but an expert on corporate bonds. Thanks for your time and answer.

Minyan Harvey

Hello Minyan Harvey, just plain "Mish" is quite fine. Thanks for asking.

In regards to the divergence you spotted, Rot is most often visible at the edges first. The same applies to both bonds and equities:

Consider Europe. The weak link was Greece, but the concern about rot quickly spread to Portugal, then Spain. I think that concern will spread to Italy as well.

In equities, the first visible crack something was amiss in the global recovery thesis was China and emerging markets, not the US. Note that the Shanghai index $SSEC led the recovery then was the first to correct. Europe followed, now the US.

$SSEC Weekly Shanghai Index

Likewise, in regards to corporate bonds, it would be normal for rot to appear first in junk.

Also note that in 2008 continuing into March of 2009 there was indiscriminate selling of everything in the corporate bond world. Bond prices reflected Armageddon that did not happen, even if in some cases it should have and would have without government intervention, as is the case in Fannie Mae and Citigroup bonds.

The administration effectively bailed out the Fannie, Freddie, and large bank bondholders totally. I think this was an enormous mistake, perpetuating again and again, "Too Big To Fail".

Other corporates, although not priced for Armageddon were cheap. Let’s face it. Intel, Walmart, Pfizer, Cisco, etc, are not headed to zero. While not priced for zero, many corporate bonds were certainly on sale.

Whether we see those same bargains again is hard to say for sure. Regardless, corporate bonds in general, even high grade corporates, are likely fully priced and then some.

Junk bonds are more than fully priced in my opinion. Many corporations that survived by rolling over debt in 2010, may not be so lucky next time. This will not only pressure bonds, but equities as well.

Junk Bonds Widen to Most Since December 

I wrote the above last night to answer Minyan Harvey. There is more news on junk bonds today from Bloomberg.

Please consider Junk Bonds Widen to Most Since December as Mutual Funds Flee

Yields on junk bonds rose to the highest since December relative to Treasuries, with prices declining on debt from American International Group Inc. to Harrah’s Entertainment Inc. on concern Europe’s debt strains will derail the global economic recovery.

Spreads widened 27 basis points yesterday to 724 basis points, or 7.24 percentage points, the highest since Dec. 9, according to Bank of America Merrill Lynch index data. That’s up from a low this year of 542 basis points on April 26.

High-yield debt has lost 4.6 percent in May, on pace for the first drop in 15 months, after gaining 73 percent from the market bottom in March 2009 through last month.

“Due to low levels of cash at mutual funds, redemptions are forcing sales,” said Brian Yelvington, head of fixed-income strategy at Knight Libertas LLC in Greenwich, Connecticut. “Investors feel the Street is long paper and until they see reduced volatility they don’t want to catch a falling knife.”

Fear of Falling Knives

Many who plowed into junk bonds are having second thoughts. Investors "don’t want to catch a falling knife".

The Bloomberg article reports First Data Corp bonds are down 17.5%, AIG bonds are down 11.1%, Harrah’s bonds are down 8.6%. Meanwhile, Investment-grade corporate bonds have gained 0.05 percent this month, the index data show.

No Sideline Cash

Mutual fund cash on hand is at an all time low. This is important from a sentiment perspective and a redemption perspective. When mutual funds are "all in" it is a measure of extreme sentiment, subject to change.

For more on sideline cash let’s flashback to March 8, 2010: Mutual Fund Cash Depletion Highest Since 1991

"Equity mutual funds are burning through cash at the fastest rate in 18 years, leaving them with the smallest reserves since 2007 in a sign that gains for the Standard & Poor’s 500 Index may slow."

It gets tiring pointing this out, but the only time money can move into the equity market is at IPO time or other offerings. Otherwise it is impossible for sideline cash to move into equities. For every buyer there is a seller. At the end of any normal equity transaction, there is as much cash on the sidelines as before.

So many misunderstand the simple mathematical function of buying and selling, that I feel obliged to make corrections.

Sentiment, Not Sideline Cash, Is The Driving Force

Share prices do not move up because sideline cash comes in (as noted above it cannot happen in the first place). Share prices rise or fall because buyers or sellers are more aggressive in what they are willing to do. In other words, shares are repriced and sentiment is the driving force.

The idea there is sideline cash is pure nonsense. The fact that mutual funds were "all in" is a measure of sentiment. I think you can see the result. It just took time.

LQD – Investment Grade Bond Fund Weekly Chart

click on chart for sharper image

Can we have another massive equity selloff without a collapse in investment grade? Perhaps, but some sort of selloff is likely. The above chart suggests a panic low in October of 2008 where literally everything was abandoned in a panic.

Right now, the chart of LQD most likely shows a flight to quality, and one I would not expect to hold, without some sort of selloff. However, I do not expect it to crater as happened in October 2008.

JNK – Lehman High Yield Bond Fund Weekly Chart

click on chart for sharper image

By the way, note the big divergence in March of 2009 with junk bonds making a lower low while investment grade making a much higher low. That was a sign of improving corporate bond conditions. Now we see weakening corporate bond conditions.

Bear in mind, I am not a corporate bond trader, I am primarily viewing things from a perspective of how corporates affect equities. The signs are not encouraging.

Mike "Mish" Shedlock

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