Yes, you guessed it. Someone out there in Fantasy Finance Land is of the opinion that a collapse in junk bonds is a signal to be bullish on stocks. I am really struggling not to start ranting about the stupidity contained in such a thought.

My anger is aroused on two fronts. Firstly that, yet again, someone whose livelihood depends on people not selling stocks is calling a bottom and that this time it’s different. Secondly, that the situation in junk bonds is being treated as a “stand alone” problem. Just like during the sub-prime collapse the message is one of containment and over reaction.

Here is a chart of the iShare HYG, which tracks 50 high yield corporate spreads:

It closed today at 96.29 coming off a 52 week low on the 22nd of 93.30 (Bloomberg). Anyone who watched the Markit AA/BBB index charts will be familiar with this chart. Notice the lower low? I wouldn’t even look at this until a higher low had been established.

Okay a confession, I saw this drivel earlier on Monday and went to Bloomberg to track the reasoning down. I know, I should know better. On finding the story I get a double whammy, it has been written using one example and then gives out a warning which is then immediately ignored! Here is the opening paragraph, written by Fabio Alves and Michael Tsang:

” Feb. 25 (Bloomberg) — Goodyear Tire & Co.’s stock climbed 14 percent in the past six weeks, while U.S. Steel Corp. gained 7 percent. Both shares rallied as their junk-rated bonds dropped.
During the past decade, a retreat in high-yield debt has foreshadowed every decline of at least 10 percent in the Standard & Poor’s 500 Index. This time bonds may be wrong, and stocks may prove more prescient, signaling corporate profits can withstand $162 billion in banks’ credit writedowns and a slowing economy.”

The way this is written, you would be hard pushed to believe that stocks have already fallen. Are we to believe that the US stock markets have not whipped about with such volatility not seen since 2001-3? I know, I know, I’m frothing at the mouth.
Apparently shares of US firms that have junk status bonds have risen over 5% in the past month as has the yield demanded to own the junk bonds. Snapshot city. Here is a chart comparing the HYG and SPY (SPX ETF):

I don’t exactly see outperformance of one instrument over another here. If anything, shares look to be joining the poor performance of junk bonds.

So when I see this:

“The stock market is acting more rationally,” said James Swanson, who helps oversee $200 billion as chief investment strategist at MFS Investment Management. “It seems to be saying, `As bad as things are, we’re not in a recession.”’

And this:

“Lincoln Anderson, who oversees $271 billion as chief investment officer at LPL Financial Services in Boston, says the worst start to a year for junk bonds since 1990 isn’t warranted.
High-yield bonds in less than two months this year have lost 2.8 percent, including coupon payments, and trade at an average of 89.18 cents on the dollar, Merrill Lynch data show. During the nine-month long recession in 2001, junk bonds declined 2.4 percent. In 1990, they fell 4.4 percent. “(Bloomberg)

I begin to wonder if I am looking at the same markets. Of course it may all be down to perception but I fear not. Just like in 2001/2 we have people out there trying to get investors to buy their funds regardless of what is happening around them.

So let me spell this out clearly and without an agenda. According to Bloomberg, every decline in the past 10 years of at least 10% in the SPX was AFTER a drop in high yield bonds. I cannot see anything in the HYG v SPY chart that suggests this pattern is broken. Junk bonds are not wrong this time because it has already happened. Pretending stock markets haven’t dropped doesn’t make it different this time.

The problem for junk bonds is not some new conundrum. Simply put, buyers of junk bonds require more yield to cover risk premium (remember Fed Fund Rates are way down from last year) as Credit Default Swaps price in the possibility of up to a 9% default rate. Couple that with a credit crash that has sucked the liquidity out of the leveraged markets and it is no wonder junk bonds are falling in price.

I see no connection to be made that bonds are not reflecting market forces at least as accurately as stocks. To say otherwise ignores the fundamental keystone of the markets, price action.

Market Snippets

UK PRESS: Nationwide will tell homebuyers today that unless they have a deposit of 25% or more of the value of a property they will face higher mortgage rates, in the latest illustration of the clampdown on lending caused by the credit crunch, the Guardian reports. The move will be a blow for first-time buyers struggling to save for a deposit and comes amid the virtual disappearance of high loan-to-value mortgages, the paper says. The credit crunch is already slowing the housing market. Provided by: Market News International

Citigroup Inc. took a kicking on Monday, down 1.5 percent to $24.74. The U.S. bank had its 2008 earnings estimate cut by more than 70 percent by Oppenheimer & Co., who said Citi may have to sell $100 billion of assets because of the U.S. credit-market slide.

On Friday Citi also announced that it was providing a $500m credit line to its Falcon Hedge Funds and that on Feb 20th had decided to bring $10Bn of assets and liabilities on to its own balance sheet. You may already know what I think about Citi.

Commentary by Mick Phoenix

on behalf of An occasional letter from The Collection Agency

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. The views in the article are for informational purpose only.