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Corporate Bonds, Derivatives, and How They Wag the Equity Markets

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To more accurately guess the primary direction of equity markets, there are better places to look to than stocks themselves.

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The next chart shows one of many available HY indices, and it is a good indicator of how aggressively buyers are bidding for bonds. Econ 101 would suggest that as supply increases, prices should go down (i.e., yields up). But that has hardly been the case.

Blips aside (mostly EU crisis related), supply has begotten demand and even junk yields have been on a steady downward path since Q1 of 2009. (You can't see it in the chart, but the junk market came back to life in January 2009, two months before equities bottomed. Not a coincidence.) Currently, yields are at some of the lowest levels since 2003, and for investment grade debt, they are at all-time lows.


Click to enlarge

So these three charts suggest that the core of corporate credit is as healthy as it has been in a decade.

The next question is: Can these happy days continue?

The first place I look to for an answer is the secondary market for recently issued bonds. If the buyers of new issues see their new purchases hold their prices, or even rise, they tend to be happy and to come back for more, even incrementally more. If secondary trading is weak, it is a major red flag. Here is why: Much of the supply of new bonds is absorbed by bond funds on a leveraged basis. These funds use leverage because they are expected to provide returns to their investors (pension funds, insurance companies, etc.) far higher than what is offered by current coupons.

If prices of bonds newly acquired on margin start falling, the funds are faced with the equivalent of "margin calls." But unlike a margin call on equities, where the holder can come up with new cash or liquidate a position at the push of a button, forced selling of bonds often occurs in a vacuum and at much lower prices than the last trade. This in turn creates additional margin calls, or forces the fund to shore up the position with new cash. Either way, capital that could have been leveraged for new purchases is now tied up in existing holdings. If this dynamic repeats in a widespread manner (as it happened in 2007-2008), next thing you know, the buyers of new issues disappear.

(As an aside, the illiquidity of the secondary market has been exacerbated in the last couple of years by banks having to shed leverage, reduce their inventory of bonds, and get out of the market-making business. This is likely to be one of the harshest unintended consequences of regulatory reforms the next time the bond market hits the skids.)

I am not aware of an easy-to-follow indicator that illustrates how secondary trading is doing, so I've resorted to keeping a rolling watch-list of recently issued bonds, and I simply track how they are trading. Not surprisingly, many of these three to six month old issues are now trading well above par -- so from that perspective, there is no inkling that the corporate bond party is about to end for good.

Positions in SPX
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