2 weeks ago I looked at the divergence between the High Yield Spread and Investment Grade Spread.
- The High Yield Spread continues to trend lower.
- The Investment Grade Spread is trending upwards.
This is a very rare situation because the 2 spreads tend to move together.
Here’s the High Yield Spread. It’s trending down.
Here’s the Investment Grade Spread. It’s trending upwards.
As I’ve said before, the High Yield Spread is a leading indicator for bear markets in stocks. Notice how it trends higher before an equities bear market begins (i.e. while the stock market is rallying in the last leg of a bull market).
*Recessions and bear markets are shaded in grey in the above charts.
High Yield Spreads and Investment Grade Spreads lead the stock market because bond market investors are typically smarter than stock market investors.
So with the Investment Grade Spread trending upwards right now, does it mean that bond market players foresee a big problem for the stock market and economy on the horizon?
The short answer is no. Same symptoms, different cause. Here’s the long answer.
Why Investment Grade Spreads are diverging from High Yield Spreads
High Yield Spreads represent the bond market’s real perception of macro risk. When the market environment becomes risky, high yield spreads are the first to surge because high yield bonds are most at risk of default. Investment Grade Spreads rally less because investment grade bonds face less of a default risk.
With High Yield Spreads falling right now, this means that the bond market perceives risk to be shrinking right now. If that’s the case, then why are Investment Grade Spreads widening? After all, aren’t investment grade bonds safer than high yield bonds?
This phenomenon is due to the Trump tax cut.
This is from Bloomberg:
Corporate America held $3.1 trillion offshore prior to the Trump tax cut. But corporate America didn’t park this money in cash. They parked it in bonds: U.S. Treasuries and corporate bonds.
Now that they’re bringing that money home, they have to bring home cash. In other words, they need to raise cash by getting rid of bonds through:
- Letting those bonds mature without reinvesting the proceeds (i.e. decrease demand for bonds), or…
- Selling those bonds (i.e. increase the supply for bonds).
Both of these actions effectively do the same thing: put downwards pressure on bond prices and upwards pressure on corporate interest rates.
Here’s why Investment Grade Spreads are going up while High Yield Spreads are falling.
The Treasury market is a lot bigger than the corporate bond market. In addition, corporate America held more corporate bonds than Treasuries offshore before Trump’s tax cut.
- Corporate America invested in Investment Grade bonds, not High Yield bonds (i.e. junk bonds). This is logical. E.g. Apple isn’t going to start making speculative bets on junk bonds. Junk bonds behave very much like stocks. And corporate America generally does not invest in other companies’ public shares.
- Corporate America dumped Treasuries because they needed to repatriate overseas cash. But since the Treasury market is so big, Treasury yields didn’t really go up.
- Corporate America dumped investment grade corporate bonds because they needed to repatriate overseas cash. Since the corporate bond market is smaller, corporate bond yields went up. Hence the Investment Grade Spread went up.
- Corporate America doesn’t really trade in High Yield bonds. Hence this capital repatriation had little impact on the High Yield spread.
In other words, the recent divergence between Investment Grade Spreads and High Yield Spreads is mostly due to Trump’s tax cut.
How to profit from the High Yield Spread
There isn’t anything particularly alarming about the recent rally in Investment Grade Spreads. This is mostly an anomally due to tax policy. It doesn’t signal that a bear market in stocks or “significant correction” is about to begin.
With that being said, here’s how you can profit from the High Yield Spread right now.
High Yield Spreads tend to go up at least 1 year before a bear market in stocks and recession begins. In addition, High Yield Spreads are pretty low right now, which means that their downside is limited.
Based on current data, the Medium-Long Term Model predicts that the current bull market has 1-1.5 years left.
Investors and traders who are aggressive can start to go long the High Yield Spread right now.
Investors and traders who are more cautious (like myself) should wait until the start of next year (2019) – when we are closer to the start of the next bear market – before going long the High Yield Spread.
So how do you profit from a rise in High Yield Spreads?
The most obvious and simplest way is to go short High Yield ETFs like JNK or HYG. Here’s HYG.
The good thing about shorting corporate high yield bonds
Shorting the stock market is very hard. Even the Medium-Long Term Model can call a “bear market” or “significant correction” too early sometimes.
*The Medium-Long Term Model tends to predict a bear market a few months before a bear market actually begins. This means that if you short the stock market when the Medium-Long Term Model predicts that a “bear market” is imminent, you might sit through losses for months before the bull market tops.
The beauty behind shorting high yield corporate bonds is that high yields and high yield spreads tend to widen BEFORE a bear market in stocks begins. This means that even if you predict an equities bear market too early, your timing for shorting bond ETFs won’t be as bad.
Do you guys know of other ways to profit from a rise in the High Yield Spread? Comment below!