Keep an Eye on U.S. Corporate Bond Spreads

Keep an Eye on U.S. Corporate Bond Spreads

One specific index would have allowed investors to near-perfectly time equity markets over the past 14 months and it points to one indicator – U.S. corporate bond spreads – as the most important to follow in the weeks ahead.

Central bank monetary policy has been a central driver of equity market performance since mid-2018. The monetary tightening by the U.S. Federal Reserve and Bank of Canada in 2018 led to extremely weak equity markets in the second half of last year. The trend was reversed on Christmas Eve with the Fed’s pivot to a more accommodative, stock-friendly policy, and equities have been rallying since.

The importance of financial conditions – the ease of credit conditions and monetary policy – is apparent in the accompanying chart. The S&P 500 (and the S&P/TSX Composite Index to a significant degree, although it’s not shown) has closely tracked the Goldman Sachs U.S. Financial Conditions Index. The Goldman index is plotted inversely to better show the trend, so a rising purple-colour line indicates lower rates and easier credit conditions.

The Financial Conditions Index has five components. The 10-year U.S. treasury yield has the largest weighting, followed by BBB-rated corporate bond spreads (the amount BBB bonds yield above comparable U.S. Treasury bonds), the trade-weighted U.S. Dollar Index, the Federal Reserve policy rate and a small (5 per cent) weighting in the S&P 500 itself.

Of the four non-S&P 500 index components, correlation analysis points to BBB spreads as by far the biggest contributor to the similarity between the path of financial conditions and the U.S. equity market. This close relationship between the volatility of bond spreads and equities can be seen in the second accompanying chart.

BBB-rated corporate bonds hold a very important position in global markets in the current environment. In a late May report, Standard & Poor’s noted that BBB bonds represents 53 per cent of all U.S. investment-grade bonds and the market capitalization of the category is more than 250 per cent larger than high yield, speculative bonds.

Importantly, BBB is the lowest-tier investment-grade rating – anything lower is considered high yield or junk. Many investment funds are prohibited from investing in junk bonds and this means that a BBB bond that gets downgraded must be sold from all of their portfolios.

The tightening monetary conditions of late 2018 put enough financial pressure on BBB-rated bond issuers that downgrades to junk status became more likely. This pushed bond spreads higher – investors demanded more compensation for the added risk in the form of higher coupon payments – which put even more pressure on these companies.

The Fed’s about-face on tightening has allowed the BBB corporate bond sector to perform well in 2019. Even so, the sheer scale of the sector and the severe penalty for downgrades makes it an important one to follow as a measure of balance sheet health for U.S. and global companies.

For more than a year, investors have been confronted with equities markets driven primarily by changes in central bank policy and monetary conditions. Until that changes, BBB-rated corporate bond spreads, as the most volatile component of financial conditions, will be an important indicator to gauge where stocks will head next. They can be tracked at the Federal Reserve 

Scott Barlow,

The Globe and Mail

Postscript,

In this age of information overload, I pass this along for my own education and awareness but with a grain of salt as I figure the underlying breadth of the market will tell me all I need to know about how to mange my risk while investing in the stock market.