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On My Radar: The Canary in the Coal Mine? It’s The High Yield Bond Market

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April 14, 2023
By Steve Blumenthal

“Would I say there will never, ever be another financial crisis? You know, probably that would be going too far, but I do think we’re much safer, and I hope that it will not be in our lifetimes, and I don’t believe it will be.”

– Janet Yellen on July 27, 2017, in an interview with the economist and Nobel laureate Robert Shiller

There are a lot of forecasts about the direction of the economy. Soft landing? Hard landing? No landing? If you’ve been reading On My Radar, you know I’m anticipating a hard landing (recession) by the fall. Of course, I could be wrong. That’s why I look to the high-yield bond market, also known as the “junk bond” market, to help figure out the timing.

The high-yield bond market is a segment of the corporate bond market that consists of companies with lower credit ratings. High-yield bonds offer a higher yield to compensate investors for the higher risk of default. And because the risk is higher, investors and creditors keep a closer watch on finances.

High-yield bonds act as the canary in the economy’s coal mine. Companies in the high-yield bond market tend to be more sensitive to changes in the economy. When the economy is doing well, these companies are more likely to generate higher revenues and profits, which can improve their creditworthiness and allow them to issue bonds (a.k.a. borrow more money) at lower interest rates. Conversely, when the economy is struggling, these companies are more likely to face financial difficulties, which also makes it more likely that they will default on their bond payments. Thus, the high-yield bond market tends to react quickly to changes in the economy.

Investors adjust their investments as they grow more optimistic or pessimistic about the economic outlook, which leads to changes in bond prices and yields. These changes can provide valuable insights into the market’s expectations for future economic performance.

Moreover, the high-yield bond market is closely linked to the broader credit market. Banks and other financial institutions often hold high-yield bonds as part of their portfolios, so changes in the high-yield bond market can affect their financial health. This, in turn, can impact their willingness and ability to lend money, which can have significant implications for the broader economy.

In summary, while the high-yield bond market is inherently risky, it can be a useful tool for predicting future economic trends. By monitoring changes in the high-yield bond market, investors and policymakers can gain valuable insights into the market’s expectations for future economic performance and adjust their strategies accordingly.

The relationship between high-yield bonds and small-cap stocks

Most investors know that because small companies are often less established and have a higher chance of failure, small company stocks tend to be riskier than larger company stocks. Consequently, they are sensitive to changes in the economy in much the same way as high-yield bonds. Small company stocks tend to outperform during economic expansions when revenue growth is strong and underperform during economic downturns. Similarly, high-yield bonds tend to perform better during economic expansions when corporate earnings and cash flow are strong, but they tend to underperform during economic downturns when the risk of default increases.

However, put your investment goober goggles on for a second. It’s worth noting that there are some key differences between the two asset classes. For instance, small company stocks tend to be more volatile and have a higher beta (a measure of volatility relative to the broader market) than high-yield bonds. Additionally, small company stocks are often more sensitive to changes in interest rates, while high-yield bonds, while sensitive to changes in interest rates, tend to be more sensitive to changes in credit spreads (the difference between the yield on a bond and a comparable risk-free asset).

Despite these differences, there are still important interactions between the high-yield bond market and small company stocks, such as the impact of credit conditions on small businesses. As mentioned earlier, banks and other financial institutions often hold high-yield bonds in their portfolios and loan money to high-yield companies. When credit conditions tighten, these institutions may reduce their risk exposure by reducing their total lending, which can lead to a decrease in lending to small businesses. Considering that small businesses are the heartbeat of our economy, one has to wonder just how much of an impact the regional banking crisis will have on small- to mid-size business liquidity.

That said, everyone is impacted by economic cycles—not just small businesses. By monitoring both the small company stock and the high-yield bond markets, investors can gain a better understanding of the broader economic outlook and adjust their investment strategies accordingly. Additionally, policymakers can use information from these markets to make informed decisions about monetary and fiscal policy. The operative word there is “can.” Unfortunately, the more likely word is “won’t.”

Here are a few quotes from each of the three former chairs of the Federal Reserve prior to the dot-com bubble, the housing bubble, and the global financial crisis:

Alan Greenspan:

  • Prior to the dot-com bubble, December 1996: “Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets.”
  • Prior to the housing bubble, February 2004: “Although we certainly cannot rule out home price declines, especially in some local markets, these declines, were they to occur, likely would not have substantial macroeconomic implications.”
  • Prior to the global financial crisis, July 2005: “We’ve never had a decline in house prices on a nationwide basis. So, what I think is more likely is that house prices will slow, maybe stabilize.”

Ben Bernanke:

  • Prior to the dot-com bubble, December 1996: “The stock market has recently reached very high levels by almost any measure. … But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?”
  • Prior to the housing bubble, March 2007: “At this juncture, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.”
  • Prior to the great financial crisis, June 2008: “The risk that the economy has entered a substantial downturn appears to have diminished.”

Janet Yellen:

  • Prior to the housing bubble, May 2006: “While the decline in housing activity has been significant and will probably continue for a while longer, I think the concerns we used to hear about the possibility of a devastating collapse—one that might be big enough to cause a recession in the U.S. economy—have been largely allayed.”
  • Prior to the global financial crisis, June 2007: “I do not expect major problems in the subprime mortgage market to spread to the rest of the economy or the financial system.”

And more recently, on July 27, 2017, in an interview with economist and Nobel laureate Robert Shiller, Janet Yellen said, “Would I say there will never, ever be another financial crisis? You know, probably that would be going too far, but I do think we’re much safer, and I hope that it will not be in our lifetimes, and I don’t believe it will be.” Bold emphasis mine.

Hu-bris: Excessive self-confidence.

I don’t buy the rhetoric. When you see it, run.

How do you monitor all this? Let’s look at the latest action in the high-yield market and small-cap stock market for clues.

Grab a coffee and find your favorite chair. Here are the sections in this week’s On My Radar:

  • The Canary in the Coal Mine? It’s The High-Yield Bond Market
  • JPMorgan’s Jamie Dimon on Interest Rates
  • Random Tweets
  • Trade Signals: CPI Inflation Update
  • Personal Note: Spring Is Here

(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)

If you are not signed up to receive the free weekly On My Radar letter, subscribe here.

The Canary in the Coal Mine? It’s The High Yield Bond Market 

First, to set the stage, take a look at how the high-yield bond market’s total return performance is similar to the stock market’s total return but with a little less volatility.

Chart 1: High Yield Corporates vs. Stocks:

Chart 2: Yield Spread vs. Treasury’s

  • 8.38% is the current yield on the Barclays High Yield Corp Bond Index
  • 3.45% is the current yield on the 10-year Treasury Note
  • The spread is the difference between the two, which is 4.93%
  • Over the last number of years, due to the Fed’s zero percent interest rate policy, the yield on high-yield bonds has been unattractively low, and the spread vs. the 10-year Treasury was also low (orange section in the middle of the chart).
  • Today, the opportunity is improving as risk gets repriced back into the system.
  • Should the Fed continue to strangle the economy with higher interest rates (or perhaps they’ve choked it enough), I anticipate we’ll see a liquidity crisis leading to much higher defaults.
  • When defaults rise, high-yield bond prices decline, and the yields go up.
  • Take a look at 2008/09. According to data from Morningstar, the average yield for high-yield bond funds peaked at around 21% in December 2008, as investors demanded higher compensation for the perceived risk of default. By the end of 2009, however, yields had declined significantly, with the average yield for high-yield bond funds dropping to around 10%.
  • I’m not saying we will get to 21% this next time. I’m saying we should be looking for “Extreme Fear.”

Chart 3: PIMCO High Yield Bond Fund

Each week in Trade Signals, I post the following PIMCO High Yield Fund chart. The signals in the lower section are trend signals based on the daily price movement of the fund. Think of it as a broad representation of what is happening in the high-yield asset class.

A popular method to use for identifying bull and bear market trends is a simple moving average line like a 30-, 50-, or 100-day moving average.

  • Pictured in the top section is a 30-day MA line (blue). Buy signals occur when the price rises above the line, and sell signals occur when the price drops below the line.
  • Know that this is a very short-term signal and will have a number of false signals.
  • What we are after is protecting capital against big declines.
  • The lower “MACD” section compares two moving averages against each other.
  • While both of these technical processes do a good job, nothing in this business is perfect. Nothing is guaranteed.

Chart 4: High Yield Bonds and Small-Cap Stocks (data from 1995 to present and 2022 to present)

We considered the similarities between small-cap stocks and high-yield bonds in the opening section of today’s letter. Let’s take a look at what the price action in small-cap stocks is telling us today.

Here is what NDR has to say,

“Many investors use junk bonds as an alternative to stocks and, in some cases, perceive them as less risky because of the cash flow that is generated. Junk bonds are defined as high-yield bonds that offer investors higher interest rates than the bonds of financially sound companies.  Small-cap companies are those businesses with annual revenues of less than $250 million.  Because of their size, spurts of growth can have dramatic effects on their earnings and stock prices.  We found that junk bonds are a great substitute for small-capitalization stocks.

Chart #B172 displays the Barclays High Yield Price Index in the top clip. Standard & Poor’s 600 Index, along with its 36-day smoothing, is shown in the middle clip. The NDR Small-Cap Advance/Decline Line, together with its 40-day smoothing, is shown in the bottom clip.  Using trend analysis, this chart shows that when small-cap trends are positive, junk bond prices tend to show healthy gains. Conversely, when these trends are falling, junk bond prices tend to fall.”

Here is how to read the chart:

  • The orange line in the cent plots the S&P 600 Small Cap Index. I’ve used a start date of 2022 so you can see when the index line crosses the dotted moving average line.
  • The light blue line plots the Advance-Decline Line of the S&P 600 Index.The advance-decline line (AD line) is a technical analysis tool used to measure the breadth of market movements in a stock exchange. It is calculated by subtracting the number of declining stocks from the number of advancing stocks and plotting the resulting line over time. The AD line provides a way to visualize the overall strength or weakness of the market by measuring the number of stocks that are moving up versus those that are moving down.If the AD line is rising, it indicates that there are more stocks advancing than declining, which is a bullish signal for the market. Conversely, if the AD line is falling, it suggests that there are more stocks declining than advancing, which is a bearish signal for the market. Traders and investors use the AD line in conjunction with other technical indicators to make informed decisions about when to buy or sell stocks or other securities.
  • The lower two data boxes show the performance based on whether both are in buy signals, just one is in a buy signal, and when both are in sell signals.
  • The shaded gray shows the current signal. It’s a buy signal.

Bottom line: Despite my ongoing debt default fundamental concerns, the current price behavior is saying we may get a little more bounce.

Chart 5: Same High Yield Bonds and Small-Cap Stocks chart – different time frame (2010 to present)

I thought I’d give you a sense of the historical performance since 2010. I was curious, given all the goodies from governments and central banks over that period of time…

In conclusion, what is clear from all of this is that high-yield bond prices underperform by a lot when small-cap stock prices and the small-cap advance-decline line are “Both Below MA.”
Finally, an important reminder from the great Sir John Templeton. I see us trying to hold on to optimism on our way to skepticism. (Arrows and green X are my notations).

 

(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)

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JP Morgan’s Jamie Dimon on Interest Rates

Jamie Dimon’s 2022 Letter to Shareholders On Interest Rates:

  • “When you analyze a stock, you look at many factors: earnings, cash flow, competition, margins, scenarios, consumer preferences, new technologies, and so on. But the math above (SB here: I posted the math below) is immovable and affects all.”

Source

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Random Tweets

US Bankruptcies are increasing. On point with what we discussed above. To be watched!

Investors have once again grown complacent.

So we want to go EV? Look at China’s grip on the EV supply chain.

More Random Tweets next week. Follow me @SBlumenthalCMG.

If you are not signed up to receive the free weekly On My Radar letter, you can subscribe here.

Trade Signals: CPI Inflation Update 

CPI was out this morning and showed modest improvement. While in the right direction, inflation remains a threat to the U.S. economy. We are on the backend of inflation wave #1, and inflation and interest rates will continue to decline into the fall. A slowing economy, slowing earnings, probable recession. Bullish for bonds. Further below, you’ll see the Trade Signals bond market indicators are all in buy signals.

My good friend Barry Habib sent this video link to me this morning, sharing his views on inflation, interest rates, and mortgage rates (all moving lower). Barry’s my go-to on all things real estate, and Zillow ranks him as one of the best forecasters in the business. He explains why he believes inflation, interest rates, and mortgage rates are heading lower in this short video, which you can find here. (Available to Trade Signals subscribers and non-subscribers today).

Following, I highlight the NDR Volume Supply vs. Volume Demand data. Think of this as Buyers vs. Sellers. More buyers than sellers, and prices go up. Conversely, when sellers dominate, prices go down. The current signal remains in a sell signal. Volume Supply vs. Demand is one of my favorite technical indicators, and I share it with you each week in TS. Let’s look at three different time frames. Not all periods are like 12-31- 1981. The return spread from 2019 to the present is more significant, while the spread from 2009 is much lower. 1981 to present

 

Source: NDR 

Oil continues its bullish move, as does gold. The U.S. equity market is bumping up against resistance with signals mixed. The dashboard of indicators is next.

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About Trade Signals

Trade Signals provides a weekly snapshot of current stock, bond, currency, and gold market trends. We provide a summary of technical indicators to help you identify where we sit in short, intermediate, and long-term cycles. We track important valuation metrics to determine the probability of future returns (i.e. when return opportunity is best/least). Trade Signals also tracks investor sentiment indicators and economic and select recession watch indicators. Trade Signals is now a low-cost subscription service, about the cost of two Starbucks lattes every month. You can find the archive of weekly Trade Signals posts (2008 through 2-15-23) by clicking here.

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Not a recommendation for you to buy or sell any security.  For information purposes only.  Please discuss needs, goals, time horizons, and risk tolerances with your advisor. Investing involves risk. You can lose some or all of your money.

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Personal Note: Spring is Here

Last Saturday afternoon, Susan and I went to the Phillies’ baseball game. There was a chill in the air, but it was mild enough to be comfortable. The stadium was packed, and I loved how many families were at the game. Cold beer, shelled peanuts—awesome. But frankly, the game was dull. With the Phillies down 0-1 at the bottom of the eighth, we nodded at each other. It was a good time to leave.

We had parked just a few blocks from the stadium at the LIVE Casino. A friend of mine is quite a proficient poker player, and he’d previously told me we should check it out. Curious and with an extra inning of time on our hands, we decided to look inside.

The first thing we noticed, peeking on the casino’s TVs, was that the Phillies were at bat in the bottom of the ninth, now down by two runs. Instead of hopping into a blackjack game, we stood and watched the end of the game as the Phillies came back and won 3-2 in the bottom of the 9th with a walk-off single.

“Damn,” Susan said. We missed an exciting ending, but hey, baseball season is long. Happy for the “W.” Our hopes remain high that the Ws continue to rack up so we get another trip to the World Series. Last year was so close.

If outdoor baseball is an indication of anything, it’s that spring is here. Time to bring the outdoor furniture out of storage. That’s on the to-do list for tomorrow, and golf is planned for Sunday—two good days in store for the weekend. Happy the weather has turned!

Wishing you a sunny weekend and much success with your favorite team.

Kindest regards,

Steve

Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Private Wealth Client Website – www.cmgprivatewealth.com
TAMP Advisor Client Webiste – www.cmgwealth.com

If you are not signed up to receive the free weekly On My Radar letter, you can sign up here. Follow me on Spotify, Twitter @SBlumenthalCMG, and LinkedIn.  

Forbes Book – On My Radar, Navigating Stock Market Cycles.  Stephen Blumenthal gives investors a game plan and the advice they need to develop a risk-minded and opportunity-based investment approach. It is about how to grow and defend your wealth. You can learn more here.

Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.

Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.

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