EmailOne person's trash is another person's treasure -- or so it has been said.
Well, for quite some time now, junk bonds have provided investors with quite a bit of treasure. They have offered high yields in a low, low interest rate world, and because of that, investors have been buying high-yield (and higher risk) bonds to generate income.
In bond-speak, that means prices have gone up and yields have gone down.
An Eye-Opening Experience
Interest rates, though, are rising. That partly explains why junk bonds have acted a little trashy at times in 2018.
There has been more to it, however, than concerns about rising interest rates, which have created rumblings about refinancing risk for high-yield issuers.
The spike in volatility in the stock market, and the ensuing correction in early February, served as an eye-opening experience for all investors as it exposed the dangers of being complacent, particularly when one is in a crowded trade.
Many pundits would argue that buying high-yield bonds has been a crowded trade; hence, there was some de-risking amid the stock market sell-off that led to selling of junk bonds and a widening in high-yield credit spreads.
A Surprise Factor
Widening credit spreads always grab the market's attention. Why? Because their leading indicator status has a way of getting market participants to start thinking about bad outcomes and the potential for unnerving market conditions.
Defaults, illiquid markets, problems refinancing and issuing new debt at attractive rates, earnings disappointments, and economic weakness/contraction are typically among the nefarious considerations.
The most prominent characterization of widening credit spreads -- and high-yield spreads in particular - is that they are a harbinger of economic weakness.
Notwithstanding the trashy behavior during the stock market correction, high-yield spreads today are narrower than they were at the start of 2018.
That may surprise some readers, yet it is fair to say that it matches the economic narrative.
Growth is picking up and the tailwind of fiscal stimulus is expected to sustain solid economic growth, and strong earnings growth, in 2018.
Presumably, it would take some exogenous factor, an overly-aggressive policy tightening by the Federal Reserve, or a vigilante run on the bond market, and a corresponding spike in yields, to force a sudden change in the economic outlook.
What It All Means
One can never say never given the unpredictability of the future.
The current message embedded in the relatively narrow high-yield spread is that there is a good bit of confidence still in the idea that the economic outlook is bright and that a recession isn't on the near horizon.
The junk bond market, therefore, continues to be known as such in name only.
To be sure, there will be a far more visible widening in high-yield spreads when the treasure hunt is up because it is thought economic and/or financial conditions are turning junky and bringing some nefarious scenarios into play for high-yield bonds.
