Monday, July 20, 2009

A Worthwhile Indicator of Investor Sentiment

One quick and dirty way to evaluate investor sentiment and risk appetite is to compare the performance of investment grade corporate bonds (LQD; top chart) with that of high yield corporates bonds (JNK; bottom chart). When investors are bullish on the economy and perceive relative safety in the economic/financial environment, they will reach for yield and buy high yield debt over investment grade alternatives. Conversely, in times of perceived economic danger, investors will tend to favor the relative safety of investment grade debt over more speculative alternatives.

We can see that high-yield bonds dramatically underperformed investment grade debt through March of this year. Note how we saw new lows in JNK in March, not confirmed by LQD. Since that time, JNK has outperformed LQD on a relative basis, reflecting a re-emergence of risk appetite. That having been said, note that LQD has retraced most of its post-Lehman losses, whereas JNK remains well below the fall 2008 highs.

Note also that, in recent weeks, JNK has underperformed LQD. I will be watching this relationship closely. New highs in stocks not accompanied by fresh risk appetite among corporate debt investors would offer a caution light for the present rally.