by Bob Stokes
Updated: November 26, 2018
Companies with low credit ratings must offer bond investors a higher yield than what these investors could get from investing in comparable investment-grade corporate and government bonds.
The higher yield compensates investors for taking the risk of investing in a company with a higher risk of defaulting.
That's when times are good. When investors actually start to worry about the future, they demand an even higher yield. That means the difference, or "spread," between these high-yield bonds (also known as "junk") and investment-grade bonds is widening.
When investors are confident about the future, these spreads tend to narrow.
With that in mind, let's go back to April 2007, when our Elliott Wave Financial Forecast noted:
When the yield spread between junk bonds and U.S. Treasuries slipped below 3% in early February (from about 10% in 2002) and rosy economic scenarios were being "broadly extrapolated forward," The Elliott Wave Financial Forecast called it a "sure sign of an impending turn toward contraction and default."
So, it was clear that investor complacency was approaching an extreme, and extremes in investor psychology don't stay that way indefinitely. Eventually, they start to move in the other direction.
In this case, the stock market topped six months later, and the start of the Great Recession followed two months after stocks topped.
Our Nov. 19 U.S. Short Term Update explained why this information is relevant today:
On October 3, the Bloomberg Barclays US Corporate High Yield Spread declined to its narrowest level since July 2007, which was the forefront of the Great Credit Crisis of 2007-2009. The 3.03% difference between the yield on junk debt and comparable U.S. Treasuries coincided with the peak in the DJIA that same day...
Junk bonds more or less trend and reverse with U.S. equities because junk debt is most often the last in line for claims on assets in the case of bankruptcy, just above that of equities.... In just a month and a half, spreads have widened 36%, to a two-year extreme.
The key takeaway is that investors have shifted from an optimistic to pessimistic mood quite quickly.
Some observers might interpret the speed of this widening in the spread as a contrarian indicator. In other words, the widening has gone too far, too fast -- so expect a reversal back to a more optimistic sentiment.
Of course, another interpretation is that this is just the start of a deeper pessimism.
By themselves, sentiment indicators aren't always definitive. When you add Elliott wave analysis, you can really put sentiment in a proper context. So, learn what our Elliott wave experts have to say. You can do so risk-free for 30 days. Look below to find out how to get started.
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