Keep An Eye On This Indicator
Due to the mounting concerns on the part of investors that the recent
sell-off in the bond market is feeding its way into the equity market, I thought
it would be useful to revisit one of my favorite market fundamental barometers
to get a sense of what’s happening. Regular readers of this column know that I like to report on the
spread, or difference, between the yields on junk bonds and those of US
Treasuries with similar maturities. This quick arithmetic calculation isolates the risk premium that
the market assigns to high yield bonds. The resulting number, or spread, can
then be used
to gauge the overall state of the economy and therefore corporate health.
The reason why the junk bond spread is such a good indicator for equities is that
investors who buy these issues not only
assume balance sheet risk — as do other corporate bond investors — but, due to
the marginal credit quality of the firms that issue these bonds, these investors
are also very aware of changes in the economy, as the performance of their
holdings is contingent on these macro developments. After all, the companies
most sensitive to big shocks are the usually the weaker ones, right?
Let me give two fairly recent examples of how the junk bonds were accurate in
measuring a sell-off in the equity markets.
Last Summer, as the Worldcom debacle was unfolding, junk bonds were sending a
very clear signal to the markets in the weeks prior to the two-month long equity
slide.
Similarly, in 2000, when the stock market bubble was reaching new highs, junk
bond spreads were widening, as the highly scrutinizing bond investors became
more pessimistic about the future of the economy and profits. It wasn’t until
September that equity investors caught on and the three year bear market in the
S&P 500
(
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What Are They Doing Now?
As evidenced in the chart above, high yield spreads over Treasuries have been
steadily falling from their highs of 1000 reached last October and are now at
564.00 . Although the current value is 1.8% above last week’s 3 year low
(remember, a low number is good here), it is nothing to be concerned with at
this point. Forward earnings continue to rise–now for 18 straight weeks–and
the economic backdrop continues to improve.Â
However, equity investors should be particularly mindful of the high yield
spread in the coming weeks in order to get a better sense of whether the rout in
Treasuries is, in fact, spilling over into the equity market.  Â