The Bearish Signs Junk Buyers Reject in Stoking ’14 Rally

This year’s unexpected bond boom may look like a rally, but it doesn’t smell like one.

At least not to Morgan Stanley strategists, who detect something amiss in the way different securities are performing relative to one another.

Here’s an example: Stocks of the smallest companies usually move in tandem with high-yield bonds. Small caps are slumping this year, with the Russell 2000 Index down 3.8 percent, while junk-rated securities have gained 4.4 percent. The extra yield investors demand to hold the notes instead of government debt has shrunk by 0.22 percentage point this year.

Then there’s this: The top-tier of speculative-grade bonds is beating the bottom level. That doesn’t make sense if investors are buying risky assets because they feel good about the economy. The lowest-ranked assets usually outperform when there’s an optimistic outlook, yet bonds rated BB have returned 4.8 percent in 2014, compared with a 4.4 percent return for securities rated CCC and lower, Bank of America Merrill Lynch index data show.

These details “are not entirely consistent with a ‘risk-on’ market,” Morgan Stanley strategists led by Adam Richmond wrote in a report today. “Given these factors, as well as low volatility, we think hedging credit risk is both cheap and a sensible strategy in this environment.”

Getting Uneasy

Wall Street analysts are growing more concerned that investors are too complacent and that this will end badly. Yes, central banks are keeping open the spigots of cheap cash, which has helped fuel gains of 75 percent since 2008 in U.S. corporate bonds from the riskiest to the most-creditworthy. Yet analysts just can’t shake the feeling that all isn’t right, especially as they refuse to accept the notion that Treasuries can keep gaining.

While the “unexpected rally in Treasuries” has benefited credit, investors shouldn’t count on that driving returns, Barclays Plc strategists Jeffrey Meli and Bradley Rogoff wrote in a report today. Corporate debt has gained 4.8 percent this year while Treasuries have returned 2.9 percent, Bank of America Merrill Lynch index data show.

It’s easy to see the rally. It’s harder to believe in it.

Before it's here, it's on the Bloomberg Terminal.