THE SMART MONEY

While equities have made new record highs this month High Yield Bonds have declined, a classic warning sign that has often led to multi-month declines. Does it matter when High Yield Bonds are not invited to the stock market party? We decided to quantify these divergences over the past several years.

Here is what we found.

Smart Money

There are a number of structural reasons why we call movements in the High Yield Bond asset class the “Smart Money”.  A key reason is liquidity. High Yield Bonds are much less liquid than stocks. Bonds are still traded over the counter, dealer to dealer based on a wide variety of inputs such as inventory, credit risk and yield spreads. For these and other reasons High Yield Bonds tend to be much more of an institutional asset class, with few individual investors in the marketplace. Stocks on the other hand can be purchased by just about anyone, anytime, at any size on an iPhone through a discount broker. Another reason is the sensitivity of High Yield bonds to the economy. High Yield Corporate Bonds are issued by companies with lower credit ratings which makes them more sensitive to fluctuations in the broad economy, and more correlated to trends in equities than higher quality corporate and municipal bonds.

Time To Pay Attention.

This month stocks are diverging from High Yield. With just two trading days to go in the month of May, the S&P 500 Index has advanced +3.5%1 while High Yield Bonds have declined -1.4%2, a spread of nearly 5%. Over the past five years negative divergences of this size have led to stock market declines in the proceeding 3 months, without exception.

 

Month S&P 500 High Yield Bonds Spread   Max Loss Next 90 Days
5/31/2007 3.40% 0.75% -2.65%   -9.05%
10/31/2007 1.4% 0.50% -0.86%   -15.50%
5/31/2008 1.51% -0.25% -1.76%   -14.06%
11/30/2009 6.16% 0.71% -5.45%   -7.97%
2/28/2010 3.12% 0.23% -2.89%   -12.02%
3/31/2012 2.80% -0.36% -3.13   -9.69%
8/31/2012 2.51% 0.88% -1.63%   -7.84%
MTD 5/29/2013 3.50% -1.50% -5.00%   …?

 

Elevated Risk

Many of these warnings have come right at major market tops as in 2007, 2008 and 2010. Stocks have enjoyed a strong first half of the year. While there is always the argument that this time will this time be different, the Smart Money is clearing warning that it’s time for risk management.

1S&P 500 Index represented by SPDR S&P 500 SPY. 2High Yield Bonds represented by Vanguard High Yield Bond Index Fund: VWEHX. Data provided by Bloomberg, LP