Tue. Oct 19th, 2021

Here’s another indication that investors are now dangerously exuberant: the difference in junk bonds has rarely been less than their current position.

This is worrying because past occasions of low garbage good differential have often preceded periods of economic problems, if not really recessions. As a result, low returns on junk bonds typically do not stay low for long.

The differential of junk bonds is the difference in the yields of junk bonds and those of comparable maturity treasuries. It represents the compensation that investors demand to take on the additional risk of holding junk bonds instead of treasuries. When the spread is low, for example, investors behave as if maintaining good garbage entails relatively little additional risk.

The following graph shows the current state of garbage spread in relation to its history since the 1990s. It is currently 3.4 percentage points, well below the 25-year average of 5.5 percentage points. As you can see, there have only been two other sustained periods since the mid-1990s, when the spread of garbage became as low as now: before the bursting of the Internet bubble and just before the Great Financial Crisis.

Certainly, as the chart also shows, the gap was briefly narrowed as low as it is today, in 2014 and 2018, and neither predicted an economic recession. However, in each case, the difference almost immediately widened considerably, rather than doubling.

It would be particularly disastrous if this duplication occurred today, given the fragile state of U.S. corporate balance sheets. As I noted earlier, most companies are barely profitable; most of the profits made collectively by all listed companies are concentrated in the 100 most profitable companies. In 2020, for example, among the companies in the S&P 1500 index, this proportion was 91.8%.

Since most companies that are not in the top 100 companies are not profitable year after year, many of their debt ratings already belong to the “junk” category. Therefore, if the garbage gap widened considerably, many of them would have serious difficulty paying the costs of debt service, even if Treasury yields remained low.

To determine the likely course of garbage spread, I measured the correlations between its level at each time and the amount that goes up or down during the following quarterly, annual, and two-year periods. In all cases there was an inverse correlation, which means that the spread of rubbish is very inverse: high differences are more often followed by lower ones, in the same way that low differences are much more frequent than not follow the highest. All of these correlations are significant at the 95% confidence level that statisticians typically use to determine if a pattern is genuine.

In particular, it should be noted that the correlations are stronger on the two-year horizon than on the one-year horizon. The correlations for the one-year horizon are in turn stronger than for the quarter-year horizon. This is significant because most other sentiment indicators have the maximum explanatory power in a quarter or in a shorter horizon. Therefore, the difference in junk bonds is one of those rare opposing indicators that can help us assess long-term prospects.

Assuming the future is like the past, we can therefore predict with some confidence that the spread of garbage is likely to be much higher than it is today in a couple of years. An economic recession is unlikely to occur in the next two years, but even if it is not, companies with lower debt quality ratings will face much higher debt service costs. Those who invest in good garbage could suffer substantial losses. Plan accordingly.

Mark Hulbert regularly contributes to MarketWatch. His Hulbert Ratings keeps track of investment bulletins that pay a fixed fee to be audited. You can contact him at [email protected]

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