We examine how US equities perform when high yield spreads are widening.
As we discussed in Monday’s feature article, CBUS 10YR SPREAD (CBUS10YRSPREAD), which measures the spread between high yield corporate bonds and US Treasures recently reversed into Xs, possibly indicating a declining appetite for credit risk. This is a worrying sign for high yield investors as widening spreads have the same effect as rising interested rates – falling bond prices. But it also has potential implications for equities. High yield spreads are often considered a barometer for the US economy (or at least economic sentiment). When investors are worried about the possibility of recession and by extension that borrowers (i.e., bond issuers) won’t be able to service their debt, they demand a higher return for the (perceived) increase in risk and high yield spreads widen. Conversely, when the economy is perceived as being strong, investors are more willing to lend and high yield spreads contract. In an extreme example, high yield spreads widened by more than 700 bps in March of 2020 amid fears of an economic collapse at the outset of the COVID-19 pandemic. Earlier this year, CBUS10YRSPREAD rose about 180 bps in March and April amid tariff worries.
Of course, the economy is not the stock market, but there is a strong relationship between the two. To see how US equities perform when high yield spreads are we widening we looked at the quarterly change of the CBUS 10 Year Spread (CBUS10YRSPREAD) for each quarter since Q2 1987 and compared it to the quarterly returns of the S&P 500 (SPX). What we found is that SPX performs significantly better in quarters when high yield spreads are narrowing, and that the magnitude of the change is also significant as SPX performed better in quarters when spreads narrowed significantly and worse when they widened by a large amount. The results are shown in the table below.
As you can see, SPX’s performance has been much better in quarters when high yield spreads have narrowed versus quarters when they have widened; the difference in performance also increased with the magnitude of the change in CBUS10YRSPREAD.
The practical implication of this relationship is that equity investors would be well-served to keep an eye on high yield spreads as widening spreads could signal trouble for stocks while narrowing spreads have historically been associated with positive returns. Another consequence of the relationship between high yield spreads and equities is that investors seeking safety and diversification from their fixed income allocations may want to limit their exposure to high yield bonds. High yield bond prices decline as spreads widen and, as we’ve seen, equities also tend to perform poorly during periods when spreads are widening. Therefore, investors with large high yield allocations are likely to see their bond portfolio decline at the same time as their equity exposure. The reversal up on CBUS10YRSPREAD's chart does not necessarily mean that the S&P will finish the quarter the red, but it is, but it does open up the possibility that we are seeing a risk-off shift in the market that may merit a bit more caution in our investment decision making.
