Junk Bonds Trying To Sound the Recession Alert

There’s an old wall street adage that says:

“A stock selloff is just a selloff, we are often told, as long as high-yield bonds hold up.”

In the chart above the purple line represents daily price bars on the S&P 500 Futures, and the yellow line shows the performance of Junk Bonds using the iShares iBoxx & High Yield Corporate Bond ETF (HYG).  

“A junk bond is a bond that carries a higher risk of default than most bonds issued by corporations or government agencies. Junk bonds represent bonds issued by companies that are financially struggling and have a high risk of defaulting or not paying their interest payments or repaying the principal.”  – Investopedia.  

When the yellow line trades down (like it has in 2022) the price of junk bonds is trading lower, while the yield on these bonds trade higher.  For an understanding of why prices and yield move in opposite directions read this.

If we take a step back, and think about this using common sense it makes sense why junk bonds would trade with a higher yield during times of uncertainty.  When there is a higher chance of default, the price of the bonds drops, which also means the yield rises.

For this reason, junk bonds can also be a solid predictor of the possibilities of a future recession.

This is the same chart as we shared above but now using a shorter time frame. The  /ES is still purple and high yield junk bonds; yellow ($HYG).

On January 24th, when the /ES Futures rallies strong off their lows, notice how the $HYG never stopped trading down?

The /ES Futures try to rally, but it seems that each time the high yield bonds just continue trading lower.

Again, if we take a step back and consider this with common sense it becomes clear that high risk bonds should be trading higher for many reasons.  The first is the yield on government bonds is moving higher, the Fed is planning to raise rates, there’s 7.5% inflation!  

Every reason points to $HYG trading way lower in price and higher in yield.

If the broad market wants to follow $HYG, which it historically does.  

You can see why we’re incredibly concerned about risks going forward, this feels like the perfect storm.  You should watch Pablo Lucena’s awesome analysis about market risks going forward.