Market Extra: Junk bond jitters may signal the start of a stock market capitulation

Key drivers of recent jitters have been a brewing fight over the next Supreme Court judge, dimming prospects for another fiscal stimulus package, the potential for a contested Presidential election after Nov. 3 and the persistence of the COVID-19 pandemic — all threatening to crack the foundation of the market’s recent gains.

The logic behind why investors should watch high-yield for signs of trouble has been that junk bonds typically are sold by America’s most indebted companies, leaving holders of such debt vulnerable to shifting expectations around the U.S. economic recovery.

That’s why during Monday’s sharp stock selloff, market participants fixated on sharp outflows in the high-yield sector as a sign that things could easily get uglier in the months to come.

Specifically, the biggest exchange-traded fund focused on sub-investment grade debt, the iShares $ High Yield Corporate Bond fund, HYG, -1.01%, was hit by nearly $1.06 billion of outflows on Monday, the largest single-day outflow since the start of the pandemic. 

“Our sense is that further HYG weakening would be the confirming signal of real risk aversion,” said Arnim Holzer, macro and correlation defense strategist at EAB Investment Group, in a Tuesday note.

The ETF ended trade Wednesday 1% lower at $83.04 a share, leaving it down 1.4% so far this week, FactSet data show.

It’s perhaps no surprise that stocks also saw sharp declines this week. The S&P 500 index SPX, -2.37% ended Wednesday down 2.4%, while the Dow Jones Industrial Average DJIA, -1.92% fell 1.9%.

In another sign of jitters in high-yield, Texas-based natural gas company Aethon United BR LP postponed its planned $700 million high-yield bond sale, Bloomberg News reported on Wednesday, while pegging it as the first U.S. junk-bond financing to be yanked since July. A call to Aethon for comment was not immediately returned.

Still, some investors think much of the recent turbulence and high-yield outflows could simply reflect prudent money managers putting cash on the sidelines in preparation for more attractive opportunities around November, when bond prices might cheapen due to volatility in riskier assets.

In other words, the sudden tightening of credit and capital outflows could be a sign of choppy waters to come, but not necessarily wholesale carnage or a retun to the temporary credit freeze seen in February as the pandemic initially bore down on the U.S.

“I think it has been the right move,” said Rob Daly, director of global fixed income at Glenmede Investment Management, in an interview.

Daly pointed out that U.S. high-yield debt already has priced in a lot of pandemic stimulus, and could be vulnerable to the continuing stalemate between members of Congress and the White House on an additional fiscal measures to offset the pandemic’s toll, given the fractious political landscape.

Even so, the sector’s safety net remains the Federal Reserve, itself, which began buying up corporate debt during the pandemic for the first time in history, including acting as a creditor to recent “fallen angels” or companies that saw their credit ratings cut from the coveted investment-grade bracket to junk bond territory.

Related: The Fed has bought $8.7 billion worth of ETFs. Here are the details

The recent junk-bond weakness has followed a broad sense of bullishness in the corporate debt for much of the last six months, which only now might be hitting reverse.

Issuance of new U.S. junk bonds this year has been smashing prior records, even as yields have neared pre-pandemic lows back in February and U.S. corporate debt loads have touched new records.

But even last week, investors still were rotating into the sector’s most beaten-down segments, narrowing spreads between its highest and lowest rated bonds along the way.

For example, the yield gap between double-B and triple-C bonds was down to 11.69 percentage points on Monday, from nearly 20 percentage points in March.