In the world of finance, it’s important to pay attention to what the market is telling us. And currently, there’s a concerning message coming from the junk-bond market.

The junk spread, which measures the difference in yields between junk bonds and U.S. Treasurys with comparable maturities, is currently at a historically narrow level. This means that investors in junk bonds believe that the additional risk they’re taking on is below average compared to the safety of investing in Treasurys. However, this optimism may be misplaced.

When we look at the balance sheets of junk-bond issuers, we see that they are already strained by the recent increase in interest rates. This leaves them with little room to maneuver in the face of a potential recession. And while the risk of a recession may have slightly decreased in recent weeks, it still remains a very real possibility. If a recession were to occur, many of these vulnerable borrowers would likely be pushed into bankruptcy.

Now, some may argue that we should trust the efficiency of the junk-bond market and not question its judgement. After all, it incorporates all available information into current prices. But history tells us that low spread levels in the past have often been followed by higher ones, and vice versa. This suggests that the junk-bond spread is a good contrarian indicator. When it is well below the average, as it currently is, it’s a sign that the spread is likely to widen in the near future.

So, while the junk-bond market may seem calm right now, it’s important for investors to be cautious. This is one of those times when it’s wise to go against the crowd and bet on the spread widening. Because in the unpredictable world of finance, it’s better to be prepared for potential risks than to blindly follow the market’s sentiment.

Read: Everyone on Wall Street loves bonds. Are bonds too popular?

Contrarian Analysis: Risk in the Economy

This historical tendency is summarized in the accompanying table.

Understanding the Pattern

A good illustration of the pattern summarized in the table is the situation that prevailed two years ago when the spread, like now, was much narrower than average. As I wrote at the time, this suggested the spread would soon widen. And it did, nearly doubling from its July 2021 low to its July 2022 high — from 3.02% to 5.99%. Contrarians wouldn’t be surprised by something similar over the next year or two.

The Hidden Risk

There are several different strategies you could pursue if you agree with this contrarian analysis. A simple one would be to avoid the junk-end of the bond-quality spectrum, staying at or close to the investment-grade end of that spectrum. A more involved strategy for betting on the junk spread’s widening would be to go long Treasurys and short junk bonds.

Regardless, the broader message of this contrarian analysis is that risk in the economy is most likely greater than what junk-bond investors are assuming.

More Insights

More: Fund managers are less bearish than they’ve been in more than a year, says Bank of America, wiping out a buy signal

Also read: Risky bonds are facing a ‘maturity wall’ that could sow more panic in markets

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