Flashing red lights!

A week ago, Exponential Investor looked at high-yield (or “junk”) bonds and the key role that they played in the broader financial markets of the United States in the 1980s.

As we noted, high-yield bonds are those that have been rated as being below investment grade by one or more of the major credit ratings agencies.

A low credit rating means high risk. It means that the agencies reckon that there is a significant probability – or a near certainty – that the issuer of the bond (which is usually a company) will default.

A default is a situation where the issuer is unable to make the regular interest payments (sometimes called the coupons, because old-fashioned bond certificates actually were attached to coupons which the holder would present in order to get paid) and/or the principal of the bond when it matures.

In practice, the risks of default are not just recognised by the ratings agencies. The risks are also recognised by bond market investors (who often move before the ratings agencies actually comment on the situation).

If the investors get worried about higher risks, they will sell the bond in question. Its market price will fall and the yield will rise.

Red light #1: widening junk bond spreads

The logical extension of all this is that you can get insights about how investors perceive risk more generally by comparing yields on a reasonable sample of high-yield bonds with those of US Treasuries.

More spread equals more risk

Click to expand

Source: Ice Data Indices, LLC, ICE BofA US High Yield Index Option-Adjusted Spread [BAMLH0A0HYM2], retrieved from FRED, Federal Reserve Bank of St. Louis. https://fred.stlouisfed.org/series/BAMLH0A0HYM2, 21 March 2022

Data from FRED, the online database provided by the Federal Reserve Bank of St. Louis, shows that, for much of the last five years, a representative basket of high-yield bonds has yielded around 3% to 4% more than the corresponding US Treasury bonds.

This difference is called the spread. If the spread widens, that is a sign that bond investors generally are becoming (a lot) more worried about the financial situation of highly indebted companies.

Conversely, the spread narrowing is a sign that bond investors are becoming more relaxed about financial conditions.

As the chart shows, the spread blew out from 3.56% on 14 February 2020 to 10.87% on 23 March 2020 amidst enormous fear about what might happen to the US and global economies as a result of the Covid-19 pandemic.

As it became clear that governments and central banks would do amazing things to prevent a global economic slump, bond investors gradually relaxed. The spread fell pretty consistently through the remainder of 2020, reaching 5.07% on 3 November.

Just over one year later, on 28 December 2021, the spread had contracted to 3.01%.

However, since that date, the spread has widened again, and was 4.16% on 14 March, a little over a week ago.

What happens to the spread in the coming weeks will provide a useful clue as to how US bond investors see the prospects for the economy.

For now, though, the widening of spreads in less than three months looks like a flashing red light – indicating trouble and financial distress ahead.

Red light #2: the move towards an inverted yield curve

To understand why this is the case, consider what has happened recently to the market for two-year US Treasury bonds.

Investors have been fretting about inflation, and the possibility that the US Federal Reserve (“the Fed” – the country’s central bank) will have to increase the federal funds rate by more than had, until recently, been expected.

As a result, two-year US Treasuries have been sold off and have fallen in price. Lower bond prices mean higher bond yields.

For 18 months, from 26 March 2020 to 28 September 2021, the yield on the two-year US Treasury bond was 0.263%, or less. Since the end of September last year, the yield has risen very steadily to 2.170%.

In the meantime, the yield on the 30-year US Treasury bond has increased from 2.006% on 28 September last year to 2.557% now.

Fixed income market analysts talk about something called the yield curve. This is the curve that appears on a chart when you plot the yields from the bonds of one government (on the vertical axis) against the maturities of the bonds (on the horizontal) axis.

A normal yield curve slopes upwards to the right. Typically, short-term bond yields will be lower than long-term bond yields. The reason for this is that if you are lending for two years, the risks are lower than they would be if you were lending for 30 years: that holds true even if the borrower is the US government.

Because the yield on the two-year bond has risen by a lot more than the yield on the 30-year bond, the yield curve has become a lot flatter.

When a yield curve flattens because the yields on the shorter-dated bonds are rising relative to those on the long-dated bonds, it is usually a sign that the economy is likely to slow.

The flattening of the US Treasury yield curve since the beginning of March has been particularly dramatic.

If the current trend continues, the yield on the two-year bond will rise above that of the 30-year bond. At that point, the yield curve will, to use the technical phrase, become inverted.

An inverted yield curve is bad news. It implies that short-term interest rates and bond yields are abnormally high. That, in turn, almost always means that a recession is imminent.

Red light #3: the Death Cross

The most recent signals from the US stock market are worrying too. As my colleague Charlie Morris pointed out in a recent edition of The Fleet Street Letter Wealth Builder, another publication of Southbank Investment Research, a Death Cross has recently formed in the chart of the MSCI World Index, a widely used measure of the global stock market.

A Death Cross is a situation where a comparatively short term (say 20-day) moving average of the index (or stock price or commodity price or whatever is being charted) crosses from above to below a suitable long-term (say 200-day) moving average.

A Death Cross is a clear sign of an imminent bear market – and further falls in share prices.

The opposite situation, when the short-term moving average crosses from below to above the long-term moving average, is called a Golden Cross.

A Golden Cross is a clear sign of an imminent bull market – and rising share prices.

Looking at the 20- and 200-day moving averages of the S&P 500 composite, a popular measure of the US stock market, a Death Cross formed on 13 March 2020 and a Golden Cross was formed on 9 June 2020.

The 20-day moving average then remained above the 200-day moving average for just over 20 months…

… until a Death Cross formed again on 14 February 2022.

Until next time,

Andrew Hutchings
Contributing Editor, Exponential Investor