Must-know: Why junk bond spreads react to market momentum

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Nov. 26 2019, Updated 8:53 p.m. ET

The relationship between economic trends and the risks in high yield debt

Yields on corporate debt securities are based on a spread over Treasury securities of similar maturities. When the economy is trending up, this benefits the revenues and profits of firms. They have an improved ability to make the payments on borrowings. This decreases their risk relative to Treasuries, resulting in relative lower credit risks and spreads.

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Last week, U.S. economic data was extremely bullish. Positive signals from the housing and manufacturing sectors and the labor market pointed to economic growth. Also, the Conference Board’s Leading Indicators Index, a forward gauge of economic growth, rose by 0.8% in September. Junk bond spreads declined as markets perceived a decline in relative risks. You can read more about these indicators in Why the financial components of the LEI Index point to GDP growth.

Part 5

Spreads on junk bonds narrow

The Option-Adjusted Spread (or OAS) for high yield debt securities, as measured by the BofA Merrill Lynch U.S. High Yield Master II Option-Adjusted Spread Index, fell by 30 basis points over the week to 4.38% on October 24.

Secondary market flows in high yield bond mutual funds

High-yield debt mutual funds recorded a net inflow of $1.7 billion in the week ending October 24. This was a reversal of the previous week’s trend with net outflows of ~$0.5 billion. Total year-to-date net outflows from high yield bond funds now stand at ~$3.9 billion, according to Lipper.

The past few weeks have seen fluctuating flows in high yield bond funds. Higher market volatility and international growth worries were responsible for much of the reported outflows in the past few weeks. However, Bill Gross’ departure from PIMCO at the end of September precipitated investor outflows from PIMCO-sponsored funds. This benefited other stock and bond market ETFs.

In September, the SPDR S&P 500 ETF (SPY), the Vanguard Total Bond Market ETF (BND), and the Vanguard Total Stock Market ETF (VTI) reported net inflows of $9.8 billion, $3.9 billion, and $2.1 billion, respectively. The iShares Core S&P Mid-Cap (IJH) and the Vanguard Total International Stock Index Fund (VXUS) had net inflows of $2.6 billion and $3.2 billion, respectively, according to Morningstar.

The next two sections will cover primary and secondary market trends in leveraged loans.

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