The stock market saw some choppy trade to end September, including a big 264-point sell off in the Dow and a nearly 2% decline in the Nasdaq on September 25 alone.
But away from the equity markets, traders and market watchers are looking someplace else for clues on what might be next for the market: high-yield bonds.
High-yield bonds are riskier fixed-income assets that typically earn investors a higher yield for taking on additional risk, such as default or early retirement.
In the low-interest rate environment, the conventional wisdom has been that high-yield bonds have been bid up, meaning that the yield on high-yield bonds has fallen, as investors “search for yield.”
At a meeting last month, BlackRock’s James Keenan said that high-yield is a “good fit in a balanced portfolio,” but said it isn’t an “opportunity” anymore.
In his October chart book, Deutsche Bank economist Torsten Slok said that with impending rate hikes, “tourists” who have moved into high-yield and investment-grade bonds will go back to rates trading.
Rate hikes are coming and this will force ‘tourists’ out of HY+IG and into rates,” Slok wrote. “This will weigh on long rates. At the same time better economic data will be pushing up short rates up. Expect short rates to move up more than long rates. As HY and IG spreads widen we could also see a sell-off in equities as investors use stocks to hedge their corporate bond exposures.”
Back in the summer in our Most Important Charts feature, Dave Lutz of JonesTrading highlighted the diverging high-yield index and the S&P 500.
The indexes rebounded through the summer, but the divergence has since widened again and has people wondering if stocks can’t help but follow high-yield lower.
Here’s a more recent chart of the high-yield/S&P 500 divergence.
And this chart from Slok shows the recent increase in the spread of high-yield bonds with corporate debt still lagging.