LONDON (Reuters) - Calling the top in world markets and getting the timing of it right seems like a lottery, but predicting the catalyst for the turnaround may be less random.
High-yield, or so-called “junk”, bonds are on a tear that puts even record-busting stock markets in the shade. Last week, the yield on the Merrill Lynch global high-yield bond index fell below 5 percent for the first time ever. The European index yields barely 2 percent.
To put that into context, European junk bonds yield less than 10-year U.S. Treasuries trading around 2.35 percent.
If there’s evidence of irrational exuberance anywhere in financial markets, this may be it. And if that’s the case, this will be where the first tremors of a broader market earthquake will likely be felt.
There’s a case to be made that high-yield bonds of firms with sub-investment grade credit ratings are in a sweet spot right now. Economic and company earnings growth are running at the fastest pace in years, yet subdued inflation means the global shift towards tighter monetary policy can be glacial.
Put together, it’s a backdrop against which both stocks and fixed income can do well. Corporate bonds, which offer a higher rate of return than sovereign debt, can do well also.
Within that universe, high-yield paper is doing even better. Ratings agency Moody’s said this week that defaults among U.S. non-financial junk-rated companies fell to a three-year low in the third quarter.
So no surprise, perhaps, that the yield on Merrill Lynch’s global high yield index dipped below 5 percent last week and European junk yields threatened to go below 2 percent.
But it’s precisely this supercharged run that should be ringing the alarm bells for investors. A selloff in high yield could hit stock markets hard.
With stocks around the world higher than they’ve ever been, it’s easy to forget that there was a 20 percent drawdown from mid-2015 to early 2016, a correction that dovetailed with a collapse of the junk bond market.
Historically, the correlation between junk bonds and stocks is nearly always positive, but had shown signs of breaking down through 2014 and early 2015, just before junk bonds and stocks began to slide.
A plunge in oil prices decimated the U.S. high-yield market, which is dominated by energy companies. The yield on Merrill’s global high-yield index jumped to nearly 10 percent in February 2016 from under 6 percent the previous May.
Investors pulled $46 billion out of high-yield bond funds in those 10 months, according to data provider EPFR, during which time MSCI’s world stock index fell 21 percent.
To put that outflow into context, the net inflow into global junk bond funds since January 2010 stands at $64 billion, EPFR figures show.
The correlation between junk bonds and equities is breaking down again. Last month, it fell to 0.18, its lowest in three years. A move back up towards historical norms and average levels would imply the two asset classes rising or falling together at a much closer speed.
Given the lofty heights both markets find themselves at now, investors will be asking whether a correction of, say, 10-20 percent is more likely than a further 10-20 percent increase.
Junk-rated companies are certainly taking advantage of the current sweet spot to borrow at these unprecedented low rates. They’ve issued $366 billion of debt so far this year, according to Thomson Reuters data, up 35 percent on last year’s total.
But with interest rates rising in the United States and Britain - albeit at the most glacial pace imaginable - that may also be about to level off.
The opinions expressed here are those of the author, a columnist for Reuters.
Reporting by Jamie McGeever; Editing by Hugh Lawson