Bond markets sending important signals
It’s been a tempestuous few weeks, and while much has been made of recent trade tensions and their effect on stocks, the fixed income markets have not received nearly as much ink. But bonds also have a tale to tell, and in May it was one of caution.
Here are three signals the fixed income markets are sending:
Credit spreads are widening
In day-to-day financial vernacular, credit spreads refer to the yield differential between bonds with credit risk and US Treasuries. Credit spreads can tell us a lot about market sentiment. Widening credit spreads imply decreased demand for corporate bonds (corporate bond yields increase) and increased demand for relatively safe US Treasury bonds (Treasury yields decrease). In other words, widening spreads signal that investors are becoming more cautious.
Not surprisingly, credit spreads narrowed during a bullish first quarter that saw stock valuations soar. That trend appears to have been arrested, however, and after bottoming out in mid-April, credit spreads have widened by more than 25 basis points.
Source: Federal Reserve Bank of St. Louis. Data reflect ICE BofAML US High Yield Master II Option-Adjusted Spread.
Verdict: Widening credit spreads point to rising market uncertainty, lower interest rates, and a flight to quality. Spreads are nowhere near where they were at the close of last year, but they could bear watching if equity volatility continues.
Fund flows have reversed course
The degree to which funds are flowing in and out of various fixed income mutual funds and ETFs can also help gauge market sentiment. Here again, the watchword is caution.
While investment-grade bond funds saw continued inflows in May, high-yield funds have seen net outflows in four of the past five weeks. In the second week of May alone, investors pulled $2.57 billion from high-yield funds—the largest withdrawal since last December.1 That’s a sharp reversal from earlier in the year, when high-yield funds saw net inflows in 13 of the first 15 weeks.
High-yield outflows have coincided with stock market volatility, which isn’t surprising, given the strong correlation between equities and high-yield bonds.
Verdict: This is a warning sign, although corporate bond funds have still seen positive net inflows year-to-date.
Part of the Treasury yield curve is inverted
A refresher: Typically, bond yields increase with their time to maturity, creating an upward-sloping yield curve. This reflects investors’ expectations for a growing economy and is considered normal.
A yield curve begins to flatten when the differential between short- and long-term yields narrows. A flattening trend in the yield curve can raise eyebrows.
An inversion occurs when short-term Treasuries yield more than longer-dated Treasuries. An inverted yield curve can be a definite red flag, as it has historically foreshadowed economic recession.
Source: FactSet Research Systems
As you can see in the chart above, a portion of the US Treasury yield curve is inverted. In fact, just this week, the yield on the 3-month Treasury bill climbed above the 10-year Treasury rate.
Verdict: The current state of the yield curve is reason for concern, especially when compared with last year.
If bonds are giving us a traffic report, it would likely be one of investors tapping the brakes in slow-and-go traffic. The freeway isn’t a parking lot, yet—but it’s no longer free-flowing.
With brake lights ahead, this may be a good time for investors to take stock of their fixed income allocation. In a challenging yield environment, corporate bonds can make sense if investors have the stomach for risk. Given current flow trends and market volatility, however, the market for bonds with significant credit risk could be in for a rough patch.
High-quality bonds have held up relatively well year-to-date, particularly given the risk-on tenor of the equity markets through April, and they are often thought of as a potential strategy for navigating market volatility. As always, it boils down to investors’ individual risk tolerance and long-term financial goals.
Analysts are expecting corporate earnings to pick up in the second quarter, which could set the equity markets in motion again. But from what the fixed income markets are signaling, it might not hurt to let off the gas a touch around that next bend.