Why the Faltering Junk Bond Market May Signal Deeper Problems Ahead

Not many have noticed but the performance of high yield bonds (also known as “junk bonds”) are breaking down.  The decline in high yield corporate debt has been modest  (-1.5%) thus far, so it’s still flying under most radars.

But I think what’s going on in the high yield market is important, even if it is only a (1.5%) decline thus far.  Something bigger may be brewing.

For one, the last month has seen high yield bonds breakdown from their uptrend for the first time in over a year.

Secondly, high yield corporate debt is highly correlated to equities.

Finally, high yield debt is also testing its five year uptrend.  A break and it would show the five year trend of higher prices (lower yields) has slowed and may finally be ending.

Junk Bonds – The First Crack in a Year

The first chart below is one I have been showing our subscribers at ETFguide.com through our twice weekly Technical Forecast.

Junk bonds as measured by the SPDR High Yield Bond ETF (NYSEARCA:JNK) have just broken their one year long uptrend.  This at a minimum means Junk bonds are not rising in price as fast as they were previously.  In other words they are losing their upward momentum as price no longer rises as fast as it was.

Not only have prices declined 1.5%, that small decline has already wiped out three months of dividend gains, one of the primary reasons investors own high yield debt ETFs.

Also displayed in the bottom section of the chart, prices have become short term oversold, the first such occurrence since June 2013.  As a result JNK has gotten a bounce, but notice that the bounce this time around is not near as strong as the bounce that occurred from a similar oversold level in 2013.  This suggests the down move may not be over.

Junk Bonds – Testing Five Year Support

Of course a 1.5% decline is considered part of any normal trending process.  But every trend change first starts with the short term before it hits the longer term, which is one of the reasons keeping an eye on the short term is important.

In other words, the cracks may be forming in the junk bond foundation, if so they will no doubt show up in the shorter term first before they are noticed in the longer term.

How do we know if this mild pullback may be the beginning of something bigger?

I am watching a similar trendline that has formed over the longer term as well.  The chart below shows that the recent pullback has brought the high yield bond trend down to test its long term trend.  In 2011, 2012, and 2013, this trend has held as prices rebounded each time it was tested.

Support and resistance trendlines are important because they combine the market’s two most important measurements for returns, time and price.  Another word for this is momentum.  Trendlines help identify the market’s momentum.  When price has stayed above the trendline, returns have been steady.  But, when prices fall below the trendline it shows that previously steady momentum of rising prices through time no longer is, and momentum changes lead trend changes.

Will the trend of higher prices in high yield debt remain in place?  A break of the trendline will warn the long term trend indeed has lost its momentum and price may be rolling over.

Junk Bonds Highly Correlated with Equities

In the bottom section of the chart above I show why it is so important for equity investors to watch the corporate bond market.  The two are highly correlated, which makes sense.

Fundamentally, corporate debt is a notch above corporate equity (NYSEARCA:SPHB) in the risk of loss pecking order.  In the event of a liquidation, bondholders will get paid before equity holders making bonds technically the lower risk of the two asset classes.

VIDEO: Why Corporate Risk is Up Since the Financial Crisis

As bond market prices decline, it shows risk has increased (measured by higher yields).  Eventually that risk will creep into equity prices.

The bottom section of the chart displays this through the high correlation.  Indeed high yield corporate debt and equities (NYSEARCA:FEX) move together, and if the junk bond market is on the verge of breaking down it is likely equities will to.

Not only is increasing risk occurring in high yield corporate (NYSEARCA:HYLD), high yield municipal debt (NYSEARCA:HYD) has fallen over 4% during the same one month period.  That chart and analysis was provided to our subscribers and shows the cracks in the foundation may be forming across multiple debt markets.

A breakdown of the five year trendline shown above is what I am watching next as it will warn the upward momentum in place on corporate high yield debt (NYSEARCA:HYG) for the last five years is no longer.

It will warn that risks are increasing.  It will warn that equities too are near at least a short term top.

The ETF Profit Strategy Newsletter utilizes a four prong approach to keep investors on the correct side of the markets.  Combining technical, fundamental, and sentiment research with  common sense helps us identify opportunities like the one junk bonds are suggesting.  Further weakness in high yield corporate bonds will no doubt be a warning sign for equities (NYSEARCA:SCHB).