By: Jim Picerno
Director of Analytics, The Milwaukee Company
There are countless metrics for assessing the risk of the stock market, but one of the more reliable relationships is the link between the spread on junk bond yields over a comparable Treasury yield.
The high-yield bond spread (a/k/a the credit spread) is the difference in the yields between the yields on low grade corporate bonds and high grade Treasury bonds. Junk bonds’ higher yields reflect their greater risk of default. Treasuries, of course, suffer no credit risk. The market’s estimate of default risk for junk bonds varies through time. Corporate defaults tend to go up during recessions and so a widening of spread between junk bond rates and Treasury bond rates has been a reliable indication that the corporate economy is weakening, and stock market risk is growing. In that sense the high yield spread is a coincident indicator (a statistical indicator that reflects the current status of the economy).
Consider the following chart, which shows a strong negative correlation between the credit spread and the one-year return for the U.S. stock market (Wilshire 5000 Index). When the spread is high, the one-year return for equities tends to be relatively low, and vice versa.
The high-yield spread can also be used as a leading indicator – i.e., as a signal that provides insight on future conditions.
For example, when the high-yield spread spiked to nearly 11 percentage points at the height of the pandemic last year, the one-year return for U.S. stocks was just about at its nadir for one-year performance: nearly a 20% loss. When the spread subsequently narrowed from the extreme spike in the spread, stocks took off.
Another way to look at this relationship is through a regression analysis, which quantifies how the two variables interact for estimating the stock market’s expected return. As the second chart shows, higher yield spreads generally equate with a relatively high return for stocks over the subsequent five years.
A one-time anomaly? Hardly. History shows that previous extremes in the high yield spread have provided relatively robust signals about the stock market’s performance outlook. Indeed, as the charts above suggest, a spread that’s sky high, or rock bottom, can be a predictor that a turning point for equities may be near.
That leads us to the current climate: a low spread and high equity return, as indicated by the blue dot in the second chart. The current 3.3 spread translates into a lower reading than roughly 86% of history (since 1997). That’s quite low, and reflects a bullish bias for stocks, based on recent history. A contrarian interpretation, using history as a guide (as shown in the two charts above), suggests that junk bonds are expensively priced, which implies a cautious or at least a more moderate outlook for the equity market relative to the recent past.
Then again, you shouldn’t assume this is a flawless forecast -- such things don’t exist in economics and finance. There is still room for even lower spreads and sustained high (or even higher) returns for stocks. The challenge is deciding when the spread has hit a peak or dropped to a trough. Tough to do in real time, but at least we know that when those points arrive, it’s probably time to start adjusting expectations relative to what’s prevailed up to that point.
True, the yield premium on junk has been lower, but the current level is in the range that should grab your attention. Perhaps an even clearer warning will arrive in the weeks and months ahead… or not. Either way, keep an eye on the spread, which is updated daily at the St. Louis Fed’s web site: https://fred.stlouisfed.org/series/BAMLH0A0HYM2