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[Ace Hanlon]

What Is Junk Telling Us About Stocks?
Tuesday November 11, 12:54 pm ET
By Edward Allen

Regular readers of this column know that I like to report on the goings on in the US junk bond market, as this tends to be a great barometer for the current state of corporate health. I like to specifically focus on the spread -- difference -- between the yields on junk bonds and those of US Treasuries with similar maturities, as this helps isolate the risk premium that the market assigns to these issues. The resulting number, or spread, can be used to gauge the overall state of the economy and therefore corporate health.

The reason is that junk bond investors 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.

Let me give two fairly recent examples of how the junk bonds were accurate in measuring the true state of the economy.

Last October, junk bond spreads hit a multi-year peak, while the stock market made multi-year lows. Both markets rebounded in the following weeks as investors became less pessimistic about the future of the economy. That is, until the end of November, when Resolution 1441 was passed at the UN and the Iraq war became more of a certainty. Interestingly though, only equity investors became skittish about their investments. Bond investors were more certain about improving corporate balance sheets, cash flows and profits. In the ensuing months, a divergence between the performance of the two asset classes emerged. The S&P 500 (CBOE:^SPX - News) pulled back, whereas junk bond spreads narrowed. It was only until March 11 that the equity markets turned north, and the positive correlation with high yield bonds resumed.

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 began. wit


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 their lowest levels (464.40) since the beginning of 2000. This, of course, is also good news for equities due to the close relationship between the two markets.