During the stock market sell-off last Thursday and Friday, the S&P 500 and Dow Jones Industrial Average pulled back 2.37% and 1.74% respectively. Furthermore, crude oil got hit very hard, dropping more than 6%, the Australian dollar, corn, and soybeans each sold off, and Treasury yields dropped. Essentially, it was the typical so-called "risk-off" market environment. However, there was one notable exception: high-yield corporate bonds.
Usually, when you get a 1%+ single-day drop in the major market indices, high-yield corporate bonds will also show notable weakness. This makes sense, as companies with lower-rated debt are regarded as more sensitive to changes in the economy. Therefore, if stocks are selling off due to perceptions about a weaker economy ahead, high-yield often sells off in concert. In fact, if you overlay a chart of the S&P 500 with that of either of the two popular high-yield corporate bond ETFs, JNK and HYG, you will notice a strong correlation in terms of price direction.
From last Wednesday's close to Friday's close, JNK was down just 0.13%. In fact, it actually closed up on Friday, the day stocks experienced the biggest portion of their two-day sell-off. Likewise, HYG was down just 0.26% during the equity market pullback. Furthermore, on Monday, both ETFs rallied enough to completely offset the minor losses of the previous two trading sessions. Stocks, on the other hand, are nowhere close to recovering the losses from Thursday and Friday.
Let's take a bit more of a detailed look at the high-yield corporate bond market on Thursday and Friday by examining the advancers versus decliners.
On Thursday, May 3, there were 736 advancers versus 517 decliners for a 1.42 ratio. On Friday, May 4, there were 564 advancers versus 537 decliners for a 1.05 ratio. The advancers-to-decliners ratio remaining above one during a two-day or longer equity market sell-off is not typical in recent months.
For example, here is a table showing the advance/decline ratio for high-yield corporates during the April 3 through April 10 sell-off in equities:
Date | Advance/Decline Ratio |
April 3, 2012 | 1.11 |
April 4, 2012 | 0.77 |
April 5, 2012 | 1 |
April 9, 2012 | 0.622 |
April 10, 2012 | 0.7 |
Notice that by day two of the sell-off, the ratio dipped strongly under one and did not move back above break-even during the sell-off. The same thing happened during the March 2 through March 6 pullback in stocks. Below is a table showing the advance/decline ratio for high-yield corporates during that time:
Date | Advance/Decline Ratio |
March 2, 2012 | 1.04 |
March 5, 2012 | 0.79 |
March 6, 2012 | 0.53 |
Just like in April, the March sell-off in equities brought with it a large drop under one for the high-yield corporate bond advance/decline ratio.
At the moment, my corporate bond portfolio includes individual bonds of eleven companies with junk rated debt. Although it's just a small fraction of the total number of issues available to trade in the world of high-yield, when glancing through the performance of those CUSIPs, I see no notable stresses or sell-offs during the recent equity market pullback. Furthermore, among the investment grade rated bonds in my corporate bond portfolio, there are some that tend to behave like high-yield debt during periods of stress in the economy. From what I can tell, those too currently show no signs of widening spreads.
Keep an eye on this divergence between stocks and high-yield debt prices. If the equity market sell-off looks like it has further room to run, high-yield is likely to play catch up at some point. If you are inclined to trade this market and you believe equities have more downside, then you likely have an opportunity to get short high-yield debt for the time being. If you're a long only investor, you prefer to buy ETFs for high-yield exposure, and you think the equity market sell-off may have room to run, then not initiating new positions in high-yield seems justified at this time. In the meantime, build cash so you are prepared to buy the pullback in high-yield, a pullback that seems inevitable if you believe equities will continue lower from here. If you have money to put to work and aren't interested in waiting, as long as you find current yields attractive and are comfortable with the possibility of mark-to-market losses, there are plenty of opportunities available.
Finally, if you are an equity investor looking for a silver lining in the recent sell-off, here it is. Perhaps the strong performance of high-yield is an indication you should be buying the recent dip in stocks. A more aggressive trader with a positive outlook for stocks might even consider a long equity, short high yield trade looking for the divergence to correct itself over the coming days.
Naturally, there are all sorts of investors with many different points of view about where financial markets will head from here. Regardless of your point of view, the recent divergence between stocks and high-yield corporate bonds can offer an opportunity for investors or traders with some conviction in their beliefs about near-term price movements to profit from the anomaly over the coming days or weeks.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
