In late August I wrote about the implications of corporate credit spread increases that we have seen in 2015. I warned readers that increases in junk credit spreads have historically been predictive of the stock market moves, especially after a prolonged period of very low spreads. There is a basic explanation for why that happens.
Junk spread is the weighted average spread of CCC or lower rated companies over the comparable Treasury security. As such, it is a pure expression of how much risk people are willing to take, how much they need to be paid for that risk. As you can see from the chart below (S&P 500 on the right y-axis; CCC or Lower spread on the left), since 2012 investors really wanted to play on the wild side – the spreads (red series) have reached historically low levels not seen since 2007.
So what? Well, as Hyman Minsky pointed out in a brilliant Financial Instability Hypothesis paper – the investors that take too much risk will eventually reach a Minsky Moment. The leverage built up in the system will start to unwind, producing deflationary force. Junk spread has historically been the canary in the coal mine. Consider a period before the 2000 dot-com bust.
The spreads started rising in August 1999, while the oblivious equity market kept going up all the way through April 2000. We all know what happened then.
What about before the 2008 crash? Surely, investors have learned that lesson. Well, no they didn’t.
That red line on the chart had been flashing danger for a long time before the equity markets figured it out. As explained above, junk debt investment is a crystallized risk bet. It is great for measuring risk taking and thus can be predictive of risky conditions. That is one explanation. Or as one fixed income manager confidently told me: “Fixed income people are just plain smarter than equity people.”
Since at RiXtrema we work with both, I can’t possibly support that explanation for why junk spreads work as a signal. Whatever makes you remember to pay attention to corporate credit spreads is worth it, even an insult.