Junk Still Going Strong

I finally had some time to update my BAA-TYX spread chart this afternoon and, like many of my other indicators, the results are not very inspiring for any remaining bears:

As you can see we had a promising upswing during the drop but since the ramp up any loss of appetite for corporate junk bonds has quickly faded. Risk is still in and bearish sentiment is out.

For the noobs: Bonds are generally classified into two groups – “investment grade” bonds and “junk” bonds. Investment grade bonds include those assigned to the top four quality categories by either Standard & Poor’s (AAA, AA, A, BBB) or Moody’s (Aaa, Aa, A, Baa).

The term “junk” is reserved for all bonds with Standard & Poor’s ratings below BBB and/or Moody’s ratings below Baa. Investment grade bonds are generally legal for purchase by banks; junk bonds are not.

The specific definitions assigned to junk bond ratings by the services help define the magnitude of the risk associated with them. Because Standard & Poor’s definitions are somewhat more comprehensive, they are quoted here:

BB, B, CCC, CC, C: Debt rated BB, B, CCC, CC, and C is regarded, on balance, as predominantly speculative with respect to capacity to pay interest and repay principal in accordance with the terms of the obligation. BB indicates the lowest degree of speculation and C the highest degree of speculation. While such debt will likely have some quality and protective characteristics, these are outweighed by large uncertainties or major risk exposures to adverse conditions.

BB: Debt rated BB has less near-term vulnerability to default than other speculative issues. However, it faces major ongoing uncertainties or exposure to adverse business, financial, or economic conditions which could lead to inadequate capacity to meet timely interest and principal payments.

B: Debt rated B has a greater vulnerability to default but currently has the capacity to meet interest payments and principal repayments. Adverse business, financial, or economic conditions will likely impair capacity or willingness to pay interest and repay principal.

Because a B rating is the single most common rating found in a junk bond portfolio, Moody’s definition of its B rating follows:

Bonds which are rated B generally lack characteristics of the desirable investment. Assurance of interest and principal payments or of maintenance of other terms of the contract over any long period of time may be small.

To resume with Standard & Poor’s:

CCC: Debt rated CCC has a currently identifiable vulnerability to default, and is dependent upon favorable business, financial, and economic conditions to meet timely payment of interest and repayment of principal. In the event of adverse business, financial, or economic conditions, it is not likely to have the capacity to pay interest and repay principal.

D: Debt rated D is in payment default.

I guess I should explain how this affects us equities/options traders.The BAA-TYX chart measures the yield spread between bonds rated one step above junk versus the yield of the supposedly most reliable and safe bond there is, the U.S. 30-year treasury bond. In the past it has been observed that a narrowing of the spread often precedes a rise in equities and inversely that a widening of the spread may be a sign of trouble ahead. Is a big drop in equities always preceded by a widening of the BAA-TYX spread? Well – sometimes it is – but if you parse through this chart you’ll also notice that it doesn’t always pan out this way and that it sometimes lags behind a little. Still, it’s something we want to be on the lookout for in case it does occur.

What does it all mean? What it means is that QE sponsored bullishness continued unmitigated and in full blast. Bond traders are usually a lot smarter than equity traders (let’s face it – most of us are small timers without much of a clue) and I do not see any indication that this trend is about to change any time soon. The BAA-TYX spread keeps narrowing further and further and it’s a visual representation of how quantitative easing is attempting to re-inflate our credit bubble just one last time.

Let’s have one for the road, shall we? Tomorrow we all dine in hell.

Cheers,

Mole