Whether looking for signs of strength or weakness in a market rally or for confirmation of a downtrend, there are a variety of indicators investors like to analyze. Breadth measures and the percentage of stocks making new highs are two good places to look. Another indicator we like to watch is spreads on high-yield bonds relative to the yield of comparable Treasuries. Although they are considered to be safer on the risk curve than equities, high-yield bonds are one area of the fixed-income universe that trades similarly to the stock market.
When looking at a rally in the equity market, you typically want to see spreads on high-yield bonds moving in the opposite direction as equities. For example, if equities are rallying, you want to see spreads on high-yield bonds narrowing. This indicates that investors are willing to take on more risk, as they are demanding lower yields to compensate them for the credit risk. Likewise, when equities are declining, high-yield spreads often widen out as investors demand more yield for what is perceived to be higher risk in the market.
In the chart below we have compared the S&P 500 (blue line) to spreads on high-yield debt (red line). For the sake of an easier comparison, we have plotted high-yield spreads on an inverted scale to better view how they track equity prices. Since the third quarter of last year, the two have tracked each other very closely. Interestingly, after the February sell-off in equities around the time of the Italian election, spreads widened (shown as a decline in the chart) while the S&P 500 sold off. In the equity rally that followed, however, spreads in high-yield debt never confirmed the rally by making a new high. This has had some bulls on edge over the last several weeks as a possible divergence between high yield and the S&P 500 emerges.
In the last couple of days, however, high-yield bonds have rallied once again, causing spreads to narrow. As of yesterday's close they fell to 466 basis points (bps) over Treasuries. That is not only a new low for the last six months, but it is also the lowest spread in two years. While a new low in high-yield spreads is not a guarantee of continued gains in equities, it is something that should help bulls sleep a little better at night -- at least until tomorrow's first-quarter GDP report.