Originally posted at The Fat Pitch
Summary: The apparent divergence between credit-risk, as seen in rising high-yield bond spreads, and equities is due primarily to the 60% drop in oil prices over the past year. There's been no remarkable rise in spreads outside of energy; these are back to being in-line with the long term mean after falling to a 7-year low in 2014. If commodity prices continue to fall, this will be a meaningful metric to watch for equity risk.
Spreads on high yield (junk) bonds relative to treasuries have widened. This implies heightened credit risk. The widening and narrowing of spreads is correlated to equity performance over time. Since mid -2014, these have diverged (data from Gavekal Capital).
Are equities setting up for a fall? The short answer is no, at least not based on this measure alone.
Spreads have, in fact, moved higher in the past year. But mid-2014 was a 7-year low. At the time, Martin Fridson, an authority on high yield bonds, said the sector was "extremely overvalued" (here). That spreads have since moved higher is therefore not surprising.
Current spreads are now back to around their 30 year mean. The overvaluation from last year appears to have corrected.
Still, spreads have diverged from equities since 2014. Why?
The energy sector is approximately 15% of the high yield market. Energy prices peaked in June 2014 and have since dropped 60%. This has materially impacted energy stocks, which have dropped nearly 30%. Prices for 7 of the other 8 sectors in the S&P are higher.
Oil prices are correlated with spreads. As oil prices fell over the past year (red line, inverted), high yield spreads have widened (blue line). In other words, credit risk rises as falling oil prices threaten producers.
[Read: Update: What to Look for When the Price of Oil Has Bottomed]
So it should not be surprising that the yield on energy bonds have doubled since mid-2014. Energy stocks and the yields have not diverged. The yield on non-energy bonds have moved sideways in 2015 as those stocks have also largely traded sideways. Again, there does not appear to be a divergence between non-energy equities and yields. In other words, non-energy credit risk is not signaling trouble for equities, at least not yet (data from Barclays).
Oil has dropped 30% in the past month; if there is significant further weakness, it's possible that contagion could infect other parts of the credit market. The same is true for other commodity producers, as those prices have also dropped. Contagion hasn't happened yet and so, right now, spreads and equities seem aligned. But this is a metric worth watching in the months ahead.
As a side note, overall spreads are at levels associated with equity lows in the past 2 years. Before then, equity lows corresponded with higher spreads.
