The Bond Market Is Screaming Louder Now

market bondsMike Larson:  Remember what I wrote in mid-August? If not, here’s a refresher:

“You know what the bond market is saying, or rather, screaming? That the stock market is toast!”

Within days of that report, the stock market suffered its worst plunge in years. Now, I’m here with a follow up message: The bond market is screaming even louder now – and not just about energy or commodities.

Just look at this updated chart of the SPDR Barclays High Yield Bond ETF (NYSEARCA:JNK), one of two benchmark ETFs that invests in the sector:

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You can see there were two brief spike lows in early 2010 and mid-2011. But other than those blink-and-you-missed-it dips, this is the lowest JNK has sunk since early 2009. Or in other words: Junk bonds have now given up every, single penny of gains they racked up in the entire post-recession bull market!

What’s more, the carnage that was previously somewhat bottled up in energy is spilling out everywhere. It’s impacting the broader commodities sector, as well as other sectors that have nothing to do with drilling for oil, digging up iron ore, or churning out steel. A Bank of America Merrill Lynch report this week noted that more than one-third of the junk bonds that tanked at least 10% recently were in neither the energy nor the materials sector.

Why is that so worrisome? Why do stock investors like you have to pay attention to these kinds of moves?

Well, as the name suggests, junk bonds are debt securities issued by companies with higher-than-normal credit risk. They compensate investors for that risk by offering higher yields.

The junk bond market absolutely exploded during the post-recession credit boom. Investors dog-piled into anything with higher yields in a world flooded with easy money. That allowed companies to sell record amounts of junky debt, as Martin wrote about earlier this week.

Companies took all the easy money they raised, and went on a buying and spending spree. But many firms didn’t build a bunch of new factories or corporate headquarters buildings … hire millions of new workers … or invest heavily in capital equipment. Instead, they bought other companies and bought their own shares.

That was great if you were a CEO or someone else with millions of shares. The value of your stock went up as the supply of shares shrunk. Merging with competing companies, firing thousands of workers, and boosting corporate profits also meant a nice, fat paycheck.

But those aren’t the kinds of corporate actions that help the broader economy in the long term. Worse, the credit cycle is now turning … and that means everything is starting to move in reverse.

Higher junk bond yields are driving up the cost of stock buybacks and M&A transactions. That’s making financial engineering less economic and rewarding, so companies are stepping back.

The elimination of the never-ending buyback bid, and the end of the massive M&A boom, is starting to put downward pressure on stock prices. That, in turn, is making junk bond investors even more worried, leading to even more selling.

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