Junk Bond Spreads are the Recession Signal to Watch

The time to panic about a recession is when junk bond spreads tell you it's coming as they are one of the most reliable indicators. The good news is we are not quite there yet, but the bad news is we could be headed there. If you see this chart from Bloomberg, it shows that European junk bond spreads are now below us junk bond spreads. And not only has that occurred from a dip in the European spreads, but it's also occurred as a result of the rise in us bond spreads. Now, the question is, why do junk bond spreads operate as a good indicator of coming recessions? And for that, we have to understand how bond prices work versus their yields. If you already understand this relationship, go ahead and just skip forward in the video to the next section. You can think of a bond as if it's an IOU or a contract that says, I'm going to pay you a specific number of dollars back in a specific amount of time to initiate this contract. I'm going to borrow money from you. Let's say $100 for one year. And in return, I'll pay you a 5% interest rate. So in one year, you're going to get $105 back from me during that year. If something happens and I lose a bunch of money, I make a bunch of bad business deals. And suddenly you think that I might not be able to pay you back your full $105 in a year. You might try and sell that contract to somebody else. Now you're not going to be able to sell it for a hundred dollars. You might be able to sell it for $90 or $80. Now here's the thing. No matter what happens, I still owe $105 back. Even if you sell that contract to somebody else for $50, I still owe $105 back, which means that if you do end up selling it and you can only get 50 bucks for it, the person that bought it is no longer getting 5% if I do pay them back, they're getting a yield of over a hundred percent because they're paying $50 and they're getting $105 back. And I'll show you why this connects into the plan in just a moment. But first I do have an important announcement about a free event that I have coming up is very important regarding what is happening in the markets and in the world right now. It is no secret that we are currently in and heading into some of the craziest and most volatile times in history. We have trade wars, market crashes, market meltups, extreme volatility in crypto markets, commercial real estate crashes, housing market reverse crashes, and the geopolitical situation around the world is changing literally by the day. And so that's why on March 27th at 7pm Eastern time, which if you notice is just a few days before Trump's next round of tariffs go live, I'm going to be hosting a free live zoom call to teach you something I call the asymmetric trade. This is a special trading strategy that can help you profit as volatility soars. In fact, over the past year and a half, I have personally used this strategy to take home returns in my own account as high as 279% 733% and even 1,299% in a matter of months as all this volatility has been playing out. And even though massive thousand percent gains are the exception and they are not the rule, I want to show you why I think the next couple of months could hand out some of the biggest asymmetric trades we've seen yet. This sounds like something you're interested. Simply click on the link in the description below and mark this date on your calendars. Thursday, March 27th, 7pm Eastern time. Attendance is completely free, but the seats on the call are limited. So sign up now and don't forget to show up early. I look forward to seeing you there. Now let's use a different example. Let's say I borrow $100 from you at 5% interest rate and then things change in the economy. My financial situation looks really good. Interest rates from other people go down. If you want to sell this debt prior to me paying you back, you might be able to sell it for $101, $102. And people might be willing to pay you for that because if they go lend money anywhere else, maybe they can only get 1%. And so if you sell this contract for $102, they can still get back more than 1% because I'm going to pay them $105. But this is important because I'm paying back 105 to their 103. Their yield that they got is less than 5%. So when we started the bond, it was a 5% bond. But when the price of that bond goes up and down, the yield on that bond goes up and down as well. Just inversely. If the price, the bond crashes, the yield on that bond goes up. If the price of that bond goes up, the yield goes down. So when the Fed raises or lowers interest rates that will push up or down the price of all existing bonds. Okay. Now that you understand the relationship of bond prices versus yields and interest rates, let's go back to junk bonds. Junk bonds are called junk bonds because they're issued by potentially riskier borrowers. When times are really good, growth is through the roof. Everybody's making a ton of money. Those junk bonds are going to have a pretty low yield right now. The interest rate on the U S government 10 year bond is right around 4.3%. So junk bonds are going to be similar to that. They're going to be a little bit higher because you are taking on a little extra risk by loaning to a high risk corporation versus the U S government who has the force of violence behind them and can always collect their taxes through force if they need to pay you back. But at the end of the day, when times are really good, you're not going to get that much more of a premium by loaning your money to a small corporation instead. However, if times turn sour and growth starts to slow and bankruptcies start to pop up all over the place and delinquencies and defaults are everywhere at that time, junk bonds will probably see their yields go up and bond funds like H Y G that invest specifically in that high yielding corporate debt will probably see a severe decrease in their price. And if we look at a longer term history of a fund like H Y G, you can see that happens fairly often. And most recently the sharpest decline was in 2020 armed with this knowledge, a very common metric that is used to predict recessions is simply the difference between the yield on safe debt, like treasuries and the yield on riskier debt, like junk bonds. And that difference is called the spread. Now I showed you in the beginning, this chart of junk bond spreads in the United States, and they have been on the decline, but recently they are popping up. So the question is how significant is that pop? Is it something that we should be worried about? Well, here's a chart of a high yield index option, adjusted spread. And you can see over the last year, this pop is fairly significant. But if we zoom out to five years, you can see that even though this pop is significant, the absolute level is still pretty muted. And the last time it really got going was in 2022. And if you remember at that time, we actually had a recession. No, it never counted as an official recession. I don't know why. Maybe it was because of whoever was in office at that time, but we had two consecutive quarters of a declining GDP, which is a recession. And so the rise in junk bond spreads here did coincide with a recession. If we zoom out to 10 years, we can see this also happened during 2020. And if we zoom out all the way back to the 90s, we can see this happened most severely during the financial crisis. And it also happened leading up to the recession in 2001. Now, as you'll notice right here, this little blip, this little rise that we are experiencing now looks insanely insignificant compared to prior recessions and even insignificant compared to 2022. But direction and speed do matter more than absolute level. And so if this continues to deteriorate, then this is a recession warning on the horizon. We are not there yet, but it's something to keep track of. Now, like I mentioned earlier, this would have a significant impact all across the market, especially on things like bond funds. And so if you are not currently prepared to take advantage of wild swings in the market like this, please do not forget to sign up for my asymmetric trading masterclass. It's linked in the description below. I told you about it earlier, and I'm going to teach you everything you need to know about how to take advantage of moves like this. As always, thank you so much for watching. Have a great day.