Junk-bond yields bode ill for stocks

More from Fortune

Small banks, big problems Sovereign wealth funds on the hunt Let us praise the venture capitalists

FORTUNE 500 Current Issue Subscribe to Fortune

NEW YORK (Fortune) -- Investors trying to figure out whether stock prices can rally in a sustained fashion may want to start looking for clues in the bond market - specifically the difference in yield between junk bonds and 10-year Treasurys.

This spread has historically been a leading indicator of stock performance - and where it's pointing these days is not in the direction most investors would like.

In times of panic (like now) institutional investors shift money from stocks and corporate bonds to the relative safety of Treasurys. Stock and corporate bond prices fall, and bond yields rise. That quickly puts a damper on business activity.

First, companies constantly borrow money to fund operations, so rising interest rates make it more expensive for them to run their businesses. That funding cost increase usually weighs on earnings results, which weigh on stock valuations.

Second, higher rates lead companies to cut back on borrowing. A drop in borrowing typically means less corporate spending and sales growth, another reason why companies won't earn as much money and stock prices will stay low.

This time around, the trend is being exacerbated by the fact that hedge funds and mutual funds are repricing bond portfolios or liquidating them. Dumping more corporate and high yield bonds onto the market depresses prices further and raises borrowing costs even more, so companies that don't have cash or were troubled before yields rose could go out of business.

Unsurprisingly, yields in the corporate bond market have recently risen to nine-year highs and high yield, or junk bonds, are trading at record levels as well. Usually junk bonds yield 4.5 to 5 percentage points more than the 10-year Treasury, but now that spread is about 14 points.

"It will be necessary for the tide to turn in the high yield and corporate market bond markets in order for 1) earnings and the economy to recover and 2) stocks to mount a sustained advance from the recent lows," wrote Michael Darda, chief economist at MKM Partners, in a recent note.

Stock prices begin to rise after enough buyers come into the high yield bond market to push prices up and yields down. It not only makes corporate bonds less appealing relative to stocks, it makes it cheaper for companies to borrow money and expand their businesses, which should boost earnings.

Darda notes that high-yield spreads narrow about three to six months before positive trends in the broader economy start pushing stock prices higher. Don't expect this inflection point to happen anytime soon.

Sandy Rufenacht, who manages the Aquila Three Peaks High Income bond fund, says bond yields won't begin to fall until investors have a sense of how a new president and the looming threat of greater regulation will affect the market. As for the longer term, worries about higher unemployment, falling home prices, and a drop in consumer spending will all help to keep corporate bond yields higher, and that's not a positive omen for stocks.

Trying to make sense of what's going on in this wild market and what it means for your portfolio? Fortune Investor Daily will provide insight and advice from leading strategists and investors to guide you through these tumultuous times.