High-yield (junk) bonds historically have had a high correlation with stocks, and for this reason, they often serve as an early warning indicator for equity investors. In the chart below, we show 15 years of history of junk bond spreads alongside stocks. Junk bond spreads have a history of widening before stocks turn down. Junk spreads peaked in May 1999 and June 2007, preceding the end of the bull market in stocks by months. Widening spreads also preceded the correction in 2011.
We bring up this relationship because junk spreads appear to be in the early stages of widening. Spreads reached a maximum compression of 2.45% in April 2014 and have since been widening, recently reaching 2.64%. Spreads are separating from the equity market, and historically this is a canary in a coal mine for equity investors to rotate into a more defensive posture.
