New Signs of Trouble in the Bond Market

Checking in on our 'early warning' indicators... New signs of trouble in the bond market… 'Spreads' are breaking out… 'Junk' is breaking down… The risk of a bear market is rising…

Regular Digest readers know we've been following a number of reliable 'early warning' indicators for a pending bear market...

These include various gauges of economic, stock market, and credit market health. However, we've also noted that we place particular importance on the latter. As Porter explained earlier this year in the April 27 Digest...

The most important indicators and warnings will come from the corporate-bond market. The three most important indicators are:

• The prices of junk bonds. As credit tightens, the prices of junk bonds will fall. You can watch junk-bond funds – like the Shares iBoxx $ High Yield Corporate Bond Fund (HYG) – to monitor these prices.

• The interest rate "spread" between high yield debt and U.S. Treasury securities. As defaults grow, the increased risk will be expressed in much higher interest rates for weak borrowers.

• The 10-year U.S. Treasury yield. If safe yields on government bonds reach 4% or more, there will be complete carnage in the corporate-bond market, where average rates to refinance outstanding debts will probably double.

We cover all of these fixed-income market indicators closely in our Stansberry's Credit Opportunities service. And just so you know, default rates right now are near all-time lows. Nobody is afraid – yet.

When we checked in on these indicators earlier this fall, all three were giving a 'green light' for stocks...

As Porter wrote in the September 21 Digest...

Junk-bond prices hit new highs in late July, foreshadowing the new highs we've seen since in the stock market...

Meanwhile, the interest-rate spread between junk bonds and U.S. Treasury bonds is virtually unchanged this year...

It remains near record lows, meaning that credit has almost never been cheaper or easier to obtain for noninvestment-grade corporate borrowers. (For non-bond-geeks: The money spigots are still wide open.)

And interest rates are still low. The yield on 10-year U.S. Treasury bonds (the single most important interest rate in the world) has risen slowly. It remains around 3%, or about the same level it reached in May. I don't believe rates at these levels will cause any problems.

As I wrote earlier, if the yield moves above 4%, that's reason to worry. For now, we're aren't trading anywhere near these levels. And if rates move up slowly enough, the threshold for trouble will move higher.

We last checked in on these indicators four weeks ago...

And despite October's big stock-market correction, we once again noted all three of them remained in positive territory.

So while we warned you that the correction could have further to run, we also showed you that the credit markets weren't worried about a major decline at that time. As we wrote in the October 25 Digest...

The yield on 10-year Treasury notes has been rising lately, yet it remains well below 4% today. Likewise, spreads between high-yield debt and U.S. Treasurys remain near all-time lows.

And high-yield bond prices have remained remarkably stable during the recent sell-off. The following chart puts these moves in perspective...

As you can see, junk bonds suffered serious declines along with stocks during the 2008-2009 financial crisis, as well as during the broad market correction in late 2015... Yet they've barely budged this year.

In short, junk bonds say it's still too early to worry about the end of this long bull market.

Today, like before, a number of the indicators we follow remain in positive territory...

However, for the first time in nearly three years, we're now seeing the first real signs of stress in the corporate credit markets.

First, as you can see, the spread between junk bonds and U.S. Treasury bonds has surged higher. It has risen from below 2.1% in September to more than 2.8% today, officially creating a "higher high"...

More concerning, after showing relative strength in October, junk-bond prices are suddenly plunging. Not only have they turned negative for the year, they've just created a "lower low" below their November 2016 bottom...

If there's a bright side, it's that 10-year U.S. Treasury yields have stopped rising for now. In fact, they have actually been moving lower. Yields have fallen from a multiyear high of 3.24% earlier this month to just 3.05% today.

To be clear, it's still early...

But these moves are concerning. For the first time in years, the credit markets are now telling us the risk of a bear market is rising.

For months now, we've been encouraging you to be "cautiously bullish." We've suggested staying long, while raising some extra cash... holding a little more gold... and "hedging" with some short sales or long put options if you have a significant percentage of your portfolio in stocks.

If you've followed that advice, you can sit tight. Continue to follow your stop losses, and you'll automatically go to cash if this correction becomes a more serious decline. However, if you haven't done so yet – especially if you've been losing sleep these last few days – we encourage you to do so now.

Again, this isn't a recommendation to sell all your stocks and go entirely to cash. As our colleague Steve Sjuggerud explained yesterday, there are still plenty of reasons to bet on higher prices from here. But as we often say, the market offers no guarantees. And if the recent decline becomes more severe, you'll be glad you did.

New 52-week highs (as of 11/19/18): Essex Property Trust (ESS) and Coca-Cola (KO).

It's been a tough couple of weeks in the markets. Let us know how you're holding up at feedback@stansberryresearch.com.

Regards,

Justin Brill
Baltimore, Maryland
November 20, 2018