Junk Bond Market Warning of Stock Market Crash

Wednesday, 20 Feb 2013 07:45 AM

By Michael Carr

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Bond traders have always been thought of as smart money. The math of the bond market is significantly more complex than is the math of stocks, so there might be some truth to that way of thinking.

Recently, professional bond traders seem to have become nervous at the same time individuals have been buyers. Based on history, when smart money sells to individual investors, it usually ends badly for individuals.

Royal Bank of Scotland data show investors in junk bond exchange-traded funds (ETFs) have withdrawn more than $500 million since the beginning of the year, according to Bloomberg. At the same time, mutual funds reported $1 billion of new deposits.

ETFs have become popular with hedge funds and other institutional investors. The funds are highly liquid and allow large traders to move quickly between markets. Mutual funds remain popular among individual investors and are usually viewed as long-term investments.

Individuals are chasing yield since interest rates are so low, leading them to junk bond funds. This switch into junk bond mutual funds is what we should expect to see as small investors try to find more income in a low-income world.

What individuals may not know is that junk bonds, or high-yield bonds, tend to deliver bond-like returns in a bull market and crash along with stocks in a bear market. Junk bonds also have historically turned down before stocks.

iShares iBoxx High Yield Corporate Bond Fund (HYG), one of the largest junk bond ETFs, has been moving lower since the end of January. That could be a bad sign for the stock market and traders should consider reducing their exposure to equities now, while stock prices are near record highs.

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