Don't Bet on a Junk Bond Bear Market Just Yet

NEW YORK (TheStreet) -- The price reversal higher in SPDR Barclays High Yield Bond (JNK) the past few days signals geopolitical risks were holding the market back, but those risks could be fading.  

Junk bond indexes spiked sharply higher this week after experiencing large outflows over the past few sessions. Investors worldwide pulled a record $7.07 billion out of high-yield junk bond funds and exchange-traded funds in the week ending Aug. 6, according to Lipper.

The catalyst for the outflows, however, was not fear of higher interest rates but geopolitical risks. The chart below compares the junk bond index to iShares Barclays 20+ Year Treasury Bond (TLT). It shows that interest rates remained low even as junk bonds broadly sold off.

JNK Chart
JNK data by YCharts

Analysts attribute the initial selloff to overextended prices to the upside and fiscal and geopolitical risks. Treasury bonds have maintained a strong uptrend in 2014 as the Federal Reserve remains committed to low rates till at least next year. This has led to rallies in many interest rate-sensitive assets such as Vanguard REIT Index ETF (VNQ), PIMCO Investment Grade Corp Bond Index ETF (CORP), iShares S&P U.S. Preferred Stock Index (PFF), and of course junk bonds.

The sudden convergence of various narratives such as Argentina’s default, strife in Gaza, violence in Iraq, and Russia’s buildup of soldiers close to Ukraine’s border became too much to bear for risk adverse investors, sparking a selloff in both equities and junk bonds.

"I am completely mindful of the geopolitical factors and unpredictably of those factors," Stephen Antczak, head of U.S. credit strategy at Citigroup, said in a note to clients. "When you factor in Putin-related headlines, it's not a positive but (rich prices, large number of new issuance in June, and fund outflows) weighed on the market more than people take into account."

As foreign risks diminish, however, a buying opportunity arises. Citigroup's model shows that high-yield spreads are now 77 basis points cheaper, compared with 45 basis points richer to fair value in June.

If there is a resurgence of accumulation in junk bonds, then the positive sentiment could fuel equities higher as well. There is an element of uncertainty that remains, but buying the dip when fear is at its greatest has been a profitable strategy the past few years.

VNQ Chart
VNQ data by YCharts
 

At the time of publication, the author held no positions in any of the stocks mentioned, although positions may change at any time.

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This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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