High Bond Yields Foreshadow Stock Market Crash

High Bond YieldsThe borrowing costs for low-rated companies are rising rapidly, suggesting that equities are due for a huge correction. David Rosenberg, chief economist at Gluskin Sheff, argues that when bondholders start demanding higher returns, the offending company will soon see its share price fall. When it happens to companies en masse, the implication is a stock market crash that could echo into a full-blown economic collapse.

Basically, higher premiums equal lower creditworthiness. Average yields on low-quality companies have risen to 7.3%, but interest on U.S. Treasuries has stayed level. T-bills are considered risk-free investments, thus they reflect the minimum cost of borrowing.

It’s the basic amount that people want in order to part with their money, which provides a baseline for measuring how investors feel about other securities. (Source: CNBC, August 14, 2015.)

The difference between yields on any debt investment and the yield on Treasuries is known as the “spread.” Rosenberg argues that spreads are drastically increasing for junk bonds, reflecting a pessimistic outlook on the future of those debtors.

“This move in high-yield spreads is on par with what we have seen when we have previously had a 9 percent correction in equities,” said Rosenberg. “Yet the stock market is off just over 2 percent (during the most recent selloff) so either the S&P 500 has more downside from here or spreads are going to have to adjust by tightening back in.”

The S&P 500 is down one percent in the last month, bringing the net gain for the year to 1.5%. Markets have been volatile, initially from a weak first quarter, then from China’s stock market crash and Greece’s stalemate with its creditors.

Indecision has been endemic, but Rosenberg believes the market will break towards the downside before stabilizing. He concluded by warning investors to “be cautious near term but [keep] an eye to buy because the dust in corrective phases tends to settle in a matter of weeks or months.”