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Junk Bonds Are (Yet Again) Not Worried

This sensitive barometer of the health of the US economy just hit a 52-week high.

As the drums of the U.S.-China trade war beat louder, one has to keep in the back of one’s mind where the point of no return is. It is probably not a specific “point,” but a gray area that is a moving target, depending on how badly the U.S. and other global economies get hurt. For example, hurting the Chinese economy also hurts Germany, due to the large trade turnover between those two countries. Germany, in turn, is the economic engine of Europe and much closer to a recession than most people think.

But what about the U.S. economy? President Trump has maintained the view that because the trade imbalance is so lopsided in favor of Chinese exports to the U.S. – about $400 billion in their favor – the trade war hurts the Chinese more than it hurts the U.S. Maybe that has been true, so far, but the question is if that will continue with the election cycle heating up in the next 14 months and the Chinese making targeted moves to hurt his reelection prospects – like stopping purchases of U.S. agricultural products.

If the U.S. economy were weak, bond investors would be running away from junk bonds, but they aren’t.

The largest and most liquid junk bond ETF is iShares iBoxx $ High Yield Corporate Bond ETF [HYG]. That sensitive barometer of the health of the U.S. economy hit a fresh 52-week high on Friday, just before all hell broke loose after Mr. Trump’s Twitter account announced the new tariff hikes. The chart (above) is a total return chart, so it includes the substantial yield this ETF produces, which is currently 5.2%. (Other chart services show charts on price action only, which makes the chart look much different.) Also, there isn’t that much duration risk as the effective duration of the high-yield bonds in the portfolio is 2.88 years.

It is true that the economy is probably not all that weak right now and that the sharp escalation of the trade war via much higher tariffs and outright cessation of purchases from Chinese state buyers can make it weaker, which is why it’s important that the trade war does not escalate any further.

What about credit spreads, which is another way (instead of price) to look at junk bonds?

The latest reading of the BofA ML U.S. High Yield index closed with a spread of 416 basis points over the relevant risk-free rate (Treasury yield). The Federal Reserve Bank of St. Louis does not report this index in real time, but because of the couple of days’ lag, the Friday reading would be closer to 450, which is considered low. The same Master High Yield Index reached a spread to the relevant Treasuries of almost 900 basis points, or double the present level, in the summer of 2011 during the Eurozone Crisis, as well as in early 2016, during the prior sharp slowdown of the Chinese economy. Also, for comparison purposes, during the sell-off in late 2018 the Master index reached a spread of 550 basis points.

The point is that the high-yield market is not too worried about the state of the U.S. economy. When the selling started in October 2018, the high yield index was remarkably calm, as it is today, which told me that the fourth-quarter sell-off was not driven by a deteriorating economy, as it is today. As the fourth-quarter sell-off progressed, the high-yield market followed the stock market lower, which would not be the case in a deteriorating economy. Historically, high-yield bonds should lead stocks lower if the economy is deteriorating, or it should lead stock higher, if the economy is making a turn after a recession.

Why the Inverted Yield Curve is Not Completely Kosher

Much has been said about the inverted 2-10 spread, which has been flipping in and out of negative territory of late and closed on Friday at just a single basis point. Does that mean a recession is coming?

Today’s inverted yield curve is not the same as the inverted yield curve of 2007. Back then, and in all prior inversions, we did not have massive global quantitative easing, and what’s more important, but related to global QE, the $15 trillion in negative-yielding global government bonds in developed markets.

That the ECB and BOJ QE distorts the Treasury yield curve and Treasury yields in general is pretty clear. If we did not have that problem in Europe, I doubt 10-year Treasury yields would be hovering near 1.5%. They would probably be 2.5%-3.0%, which would most certainly not cause the yield curve to be inverted.

There are a number of things that The Donald and his counterpart, The Sun Tzu Disciple from Beijing, can do to make that inverted yield curve a self-fulfilling prophecy, but I do not believe they have done them yet, even after Friday’s Tweet storm.


Equities Contributor: Ivan Martchev

Source: Equities News

The Fed model compares the return profile of stocks and US government bonds.