Market Risk Signal – Its Probably Not The Time To Be Buying A Bunch Of Junk Debt

by Dave
There is a very old indicator for perceived credit risk in the market; its the interest rate spread between BAA rated bonds, and AAA rated bonds.   It represents market players moving money between 2 different trades:
BAA: “I want to maximize interest payments”
AAA: “I’m worried about not getting paid back.”
Here’s what that looks like dating back to the beginning of time.  You can see we’re at a relatively low point right now, which says the credit market isn’t worried at the moment.  “I want to maximize interest payments.”  Also known as “risk on.”

I constructed a forecaster for the spread, training it on daily BAA-AAA data that dates back to 1986.   (The chart above uses monthly data that goes back to 1919).  The forecaster is suggesting that it is seeing a low right now – since this chart represents credit risk, it is currently “long risk” – it thinks risk will increase in the near future. You will notice that there are headfakes now and then, but it largely gets the trend right over time.
In other words, its probably not the time to be buying a bunch of junk debt.

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