• Wealth Management

Don't Misread Bond Market Signals

Some investors may be mistaking the relative calm of the high yield bond market for a green light to take more risk.

While I continue to think stocks should rise more this year, my outlook for the bond market is decidedly less optimistic. 

I don’t predict a major downturn in fixed income, but I think the way different types of bonds are performing relative to each other is being misinterpreted by some investors as a green light to take more risk. In fact, I think investors should dial back on risk in their bond portfolios.

My line of thinking is going to get pretty technical fast, but bear with me and I think you’ll find this interesting.

There’s an anomaly going on in the market where high yield bonds (sometimes called junk bonds, since they are issued by companies that are rated below investment grade) have stayed roughly flat, while stocks and investment grade bonds have declined moderately in price this year. This is curious since high yield usually correlates with equities and does worse than investment grade bonds (which tend to be much more stable) when stocks are volatile.

Investors often find it a bullish indicator when high yield bonds perform better than investment grade bonds (in Wall Street parlance, this is referred to as the spread, or the difference between the yield on a junk bond and an investment grade bond, tightening). When spreads tighten, it may reflect that investors see a lower likelihood of default among heavily indebted companies and expect credit quality to improve more broadly.

Currently the spread between investment grade and junk-rated bonds is as tight as it has been in nearly six years. That’s prompted some bullish investors to shrug off the recent volatility in markets as just a temporary pause. Others have decided that investment grade bonds must be cheap if their yields are so close to that of junk bonds.

I’m not a fan of either view. Instead, I think the narrow credit spread may be due to idiosyncratic or short-term factors that could evaporate. For example, junk bonds are performing well partly because issuance has dropped as banks, due to deregulation, are lending more to small and mid-sized companies. Higher oil prices also tend to provide a big boost to junk bonds simply because there is a high proportion of energy companies in the high yield index.

Bottom Line: Financial conditions may worsen in the second half of the year as the Federal Reserve is expected to continue to raise rates and earnings growth may peak. Stocks are likely to rise from here, but market leadership will probably shift to more defensive sectors and credit spreads could widen. My suggestion: If you have money to invest in fixed income, consider putting it in in very short-term bonds, or perhaps a money market fund or short-term bond fund.

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