Use Junk Bond ETF to Track Market Direction?

24 November 2010

Introduction

It was said that Junk Bond traders are knowledgeable, involved, and speculative investors. Junk bonds offer higher future return than corporate investment-grade bonds. Because of the higher volatility and risk, Junk Bond traders are often more sensitive to the market movements. Let’s examine if we can use their trading behaviour to track the general market direction.

Junk Bond ETFs

The market offers 2 junk bond ETFs; they are iShares iBoxx $ High-Yield Corporate Bond (HYG) and SPDR Barclays Capital High-Yield Bond (JNK). Their data can be downloaded from Yahoo Finance for analysis and tracking.

How Did Junk Bond Perform?

In order to filter out the noises, we will examine the monthly plot first as shown

HYG appears to be tracking DOW quite nicely during the period from 2007 to 2010. From then on, DOW took off and HYG was not doing well for some reasons. This chart does not tell much. It only tells that junk bond buyers were not as confident and as active as stock market players in the recent months.

Correlation with DOW

If we add a chart that shows direct correlation with DOW, the picture will be as shown:-

It is clear that though the Junk Bond traders were not as confident but they were not losing track. They hold-on to play the bonds during periods between 2009 to date except that they did not respond as fast to sell their bonds in 2008 until the stock market had almost bottomed. They also buy bonds when market is falling.

From the chart, one can tell that junk bond investors are always investing ahead of the stock market. So there is a time lag between the stock and the junk bond tradings.

Applying the Time Lag

When one projects HYG 6 days in the future and correlates back to DOW, one will find a completely different picture as shown in the attached.

 The new indicator tracks closely with DOW. It gives signals ahead as to where DOW will move next. The chart shows that the stock market is presently trending downwards but there is no immediate danger until the new indicator crosses below the zero line.

What about the Weekly and Daily Charts?

There are far too many noises to track the market using weekly or daily charts. However, one can still gauge if the junk bond investors are active although the signal will be confusing.

How to build the indicator

If one has metastock or similar software, one can build the new indicator using the following formula:-

Correl(Security("C:\MetaStock Data\sample\I\IDJI-1",C),Security("HYG-1",C),5,6);0

Conclusion

The Junk Bond ETFs can be used as an alternative indicator to track the direction. The monthly chart especially the correlation chart projected 6 days into the future has a much clearer picture;  however,  it does not track better than the US Long Term Mutual Fund flow indicator described here.