Market participants have been closely watching high-yield bonds.
The Bloomberg USD High Yield Corporate Bond Index has tumbled to a level seen during the eurozone debt crisis back in August and September 2011. That spells soaring yield.
Energy account for over 15 percent of the benchmark, while other raw materials represent around 10 percent. They make up to around a quarter of the index.
The energy index has fallen 9.3 percent so far this year while that for raw materials is down 2.7 percent amid lower oil prices and expectation of a US rate hike.
As a result, the high yield bond index swung to a loss of 0.6 percent from its previous rally of up to 4.8 percent, lagging far behind the S&P 500 index.
Nevertheless, high-yield bonds usually have high risks, just like equities.
It seems that the market focus has shifted to high-yield bonds. But it could return to equities if high-yield bonds fare badly.
The high-yield bond index has had a correlation coefficient of up to 90 percent with S&P 500 since it was created in 2010. That means both markets usually move in tandem with each other for most of the time.
Also, the spread between high-yield bonds and the US 10-year treasury is always considered as a crystal ball for reading into the future market.
Widening spread either indicates cooling market appetite for high-yield bonds, or increasing demand for safe-haven 10-year treasuries, or both. This usually occurs when investors seek safe havens amid financial market volatility.
In fact, the Bloomberg USD High Yield Corporate Bond Index moves almost in tandem with the Volatility Index (VIX).
Both benchmarks have reflected the equity market’s ups and downs during each of the past financial market routs, including the fall of Long-Term Capital Management (LTCM) in 1998, the September 11 attacks in 2001, the market crash in 2002, the financial crisis in 2008, the eurozone debt crisis in 2010 and 2011, and even the market meltdown this August.
More importantly, the interest spread of high-yield bonds first touched the lowest level after the financial crisis in July 2014. It occurred 10 days before the VIX index. Then the spread started to pick up, which was in line with the stock market boom.
Experts from the New York University and the Federal Reserve Bank of New York pointed out as early as 15 years ago that the high-yield bonds’ spread contains a sea of financial market information, which helps in predicting the market much better than any other leading indices.
They found that the high-yield bond spread offers the best indicator of economic cycles compared with a number of other benchmarks.
The spread is little affected by the US Federal Reserve’s monetary policy. In fact, high-yield bond spread is the most sensitive to default risks of corporates, thus indicating the overall economic activity and performance of a specific company.
Since 1987, high-yield bond spread has moved two to eight quarters ahead, and the index has precisely predicted the economic downturns in 1989, 2000 and 2007.
The current economic and market situation is quite similar to that in 2000.
This article appeared in the Hong Kong Economic Journal on Nov. 26.
Translation by Julie Zhu
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