By Mark Hulbert, MarketWatch
(Correction: Changes S&P 500 return to 10.7% from 0.7% in ninth paragraph.)
CHAPEL HILL, N.C. — If you’re the worrying investor type — and there appear to be fewer and fewer of us these days — then look no further than the shrinking spread between the yields on junk bonds and comparable Treasurys.
This spread, sometimes referred to as the high-yield (or junk) spread, is currently in the vicinity of 3.5 percentage points (as judged by the BofA Merrill US High Yield Option-Adjusted Spread). That means that junk-bond investors on average are requiring that they be paid a yield of just 3.5 percentage points more than if they had instead invested in Treasurys of the same maturities.
That’s not much compensation for the considerably higher risk associated with junk bonds. The bonds are called “junk” for reason, after all; it’s not clear that their issuers will survive unless all the economic stars are in alignment. An economic downturn would be fatal to many of them, and in that event junk bond investors wouldn’t just forfeit their interest payments — they’d lose principal as well.
The average high-yield spread over the last 20 years has been 5.7 percentage points. And it often spells economic trouble when the spread drops to levels in the vicinity of where it stands today.
The record low for the spread (at least since 1996) came in the summer of 2007, when it dropped to 2.4 percentage points. In retrospect, of course, that seems incredible, since the 2008 financial crisis was just around the corner. In the dark days of that crisis, the high-yield spread skyrocketed to 20 percentage points.
Furthermore, as former hedge-fund manager Doug Kass is fond of saying, “risk happens fast.” So we may not have much time to react when the junk spread does begin to widen.
In an email earlier this week, he made this point by referring to the junk bonds of Toys R Us: In just three weeks in September, the bonds plunged from near par to just 25% of par. Kass in his email wrote: “I am shocked that the bond guys missed a junk credit like Toys R Us so badly.”
During this same three-week period, by the way, the Dow Jones Industrial Average /quotes/zigman/627449/realtime DJIA +0.58% rose 2.5%. Kass believes stock market investors are burying their heads in the sand about what the junk bond market is telling us.
George Putnam agrees. He is editor of The Turnaround Letter, a contrarian service that becomes interested in junk bonds only when they are hugely out of favor. That’s just the opposite of what we’re seeing now, of course. Putnam is one of the few among those whose performance I monitor who has beaten the stock market on a real-world basis over the long term. I calculate that his model portfolios, on average, has delivered an annual return of 11.7% — versus the Standard & Poor’s 500 index’s /quotes/zigman/3870025/realtime SPX +0.90% 10.7% — since the late 1980s, including dividends.
In an email, Putnam wrote: “I believe that the current very narrow spreads do not adequately compensate investors for the level of risk that they are taking on if they buy high-yield bonds today. I think that we will see the default rate increase, perhaps sharply, in the not too distant future.”
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One big source of Putnam’s worry in this regard: “There is a huge amount of lower-quality debt coming due over the next several years. Even if the debt markets remain placid, not all of the issuers of that debt will be able to refinance it, and some will default.”
That alone would cause the spread to widen, but what if there is an economic downturn? “A recession would really push up the default rate,” Putnam adds.
To be sure, a low spread doesn’t mean guarantee immediate trouble. Notice from the chart that the high-yield spread got as low as it is now in the summer of 2014, and a bear market didn’t follow. Even so, however, the stock market over the subsequent 18 months was slightly down.
In any case, Kass says we should be on the lookout for a widening of the spread. He predicts that such a widening will be an early warning sign of an imminent drop in stocks.
It may be that such a widening has already begun. Prices of high-yield bonds have tumbled over the last three days, and 2017 returns, as measured by the iShares iBoxx $ High-Yield Corporate Bond ETF /quotes/zigman/1505276/composite HYG +0.01% , have shrunk to around just 0.43% through Thursday.