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Will Junk Bonds Bless or Curse the Rest of the Market?

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The fact that junk bonds are not leading equities higher needs to be noticed, as a similar setup with volatility warned us of the September price highs.

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There have been many themes throughout this market recovery, now in its fifth year. The Fed's ever-present invisible hand, interest rates that remain near historical lows, and an investor persistently searching for higher yields are just a handful of the many mega themes that have shaped these markets. However, with most things in life there are usually unintended consequences, both good and bad. One of these unintended consequences is the extreme correlation now among most major asset classes.

This in and of itself creates a greater challenge in obtaining a "diversified" portfolio. Some examples of this increased correlation border on absurd such as the now much higher correlation between European and American equity markets or the significant connection between oil prices and equity markets.

In a few instances, though, such high correlations make more sense. The high yield debt market is one such example, actually helping us make more informed investment decisions.

Junk Vs. Equity

Rightly so, high yield debt, also referred to as speculative grade or junk bonds, is very similar to its equity counterpart. Junk bonds (SPDR Barclays Capital High Yield Bnd ETF (NYSEARCA:JNK)) are the riskiest and generally the last of the debt tranches to get paid during any sort of liquidation, the final rung before equity holders. As the last tranche of debt, their bond payments are also the last interest service paid, just before equity dividends, so generally the risks between the two are similar compared to other corporate debt.

All of these similarities show up in a very high rolling correlation between equity markets and high yield bonds. When the equity markets are up, typically so are junk bonds. When junk bonds are down, typically so are stocks.

Given the fundamental similarities and high correlation between the high yield and equity markets, it makes sense to notice when these two markets are not behaving similarly, and currently JNK is not confirming the S&P's new price highs.

Is Junk Blessing Us?

Knowing that two markets are highly correlated means we can follow both those markets and see when one is not behaving as expected. Knowing that these two markets should be much correlated allows us even more comfort in that expectation, icing on the cake, so to speak.

Looking at the chart below, JNK thus far has not made a new high above its May levels. Meanwhile most equity markets have and that is important.



Given the long term history of the two markets and the fact that they eventually always confirm one another, a high probability trade opportunity presents itself.

Buying JNK with the expectation it should do as it always has, and confirm the S&P's new high in price is thus the play here. The target would be a new JNK high above $41.

Is Junk Cursing Us?

However, the fact that JNK has not made a new high yet, after five months and after two more new highs in the S&P 500 (INDEXSP:.INX) is troublesome. Could junk actually be warning us?

An old saying on Wall Street is, "The bond market is smarter than the stock market." There are a few reasons for this, but generally it's because the bond market is so much larger and with much less retail (i.e. dumb money) influence.

The fact that junk bonds are not leading equities higher here needs to be noticed, as a similar setup with volatility warned us of the September price highs.

JNK long positions need to be watched closely. If certain price levels we are watching break down, it will be a sign that this market top indeed is different than the previous ones as the non-confirmation by JNK warns of another top.

Junk has been warning us since the May highs, but will it finally bless this market's new all-time high with its own high, or will it again curse this market's rally like it did in August and September?

Editor's note: This story by Chad Karnes originally appeared on ETFguide.com.

To read more from ETFguide, see:

Will US Public Debt Reach $22 Trillion by Feb. 2014?

Softening the Blow for VXX Longs

The Dow's Flaws Uncovered
No positions in stocks mentioned.
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