What Do Junk Bonds Know That Stocks Don’t?July 28, 2014
From a theoretical standpoint equity and high yield debt are not all that different. In both cases consideration of the return of one’s capital plays a large part in the investment process since both forms of capital are at the bottom of the capital structure. In the case of a bankruptcy, both forms of capital are first in line for haircuts.
It’s not surprising then to observe an extremely high correlation between high yield spreads and stocks. Indeed, as the charts below demonstrate, the daily correlation between high yield spreads and the S&P 500 is somewhere between .9-.95 depending on the time frame.
So with high yield spreads widening out by more than 60bps over the last month, what do junk bonds know that stocks don’t? According to our charts below, the S&P 500 should be trading somewhere around 1800 instead of closer to 2000.