What junk bonds are saying about the stock market

Traders signal orders on the financial floor at CME Group's Chicago Board of Trade.
Tim Boyle | Bloomberg | Getty Images
Traders signal orders on the financial floor at CME Group's Chicago Board of Trade.

Junk bonds have fallen about 3 percent since their peak in late June, and some traders expect the broader stock market, which traded flat since then, to follow suit—perhaps imminently.

"Equities are unlikely to rally in the midst of substantial a high-yield selloff," said one hedge-fund manager who focuses on the credit markets, referring to the junk bond market by its industry name. "There will be a correction at some point," he added, "whether it just started, or in the next six months."

Indeed, certain hedge-fund managers have spent recent months decrying what they see as an overzealous stock market, fueled by misguided easy-money policies in the U.S. and beyond.

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Late in the spring, fund managers David Einhorn and Dan Loeb argued that some business sectors were experiencing bubble-like valuations and were bound to pop; more recently, in a late-July investor letter, money managers at the $25 billion hedge fund Elliott Management called the U.S. stock market "frothy."

"Financial asset prices are artificial, the equilibrium is temporary, the lack of volatility is a trap, and when the whole thing bursts, there will truly be hell to pay," wrote the Elliott managers. "Investors are 'seeking yield' now in assets of lower and lower quality, with more and more leverage, and with less and less yield to compensate for risk."

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Despite some recent wobbliness, the S&P 500 has performed solidly so far this year, rising about 4.5 percent through July and outperforming many hedge funds, which are up an average of 3.2 percent (through June, the most recent period for which performance data is available). But July proved nettlesome for a number of fund managers, including Einhorn, Loeb and Jana Partners, all of which fell 1 percent or more during the month.

Amid the skepticism, a number of prominent hedge funds—including Ellington Management, Tilden Park Capital and Libremax Capital—are shorting baskets of junk bonds, according to people familiar with the matter.

Still, some of those bets are intended more as hedges against a drop in certain other credit-market holdings than as an outright short, say these people—suggesting that traders are still uncertain as to whether the reversals of recent weeks in both the junk-bond and the stock markets are here to stay.

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"I think the market was simply ahead of itself and overdue for a correction," said one major stock-fund manager on Monday, as the blue-chip markets regained some of the ground that had been lost during the prior week. In the S&P 500, he added, the market would likely find stability at the 1,880 level, or at the 1,850 in the "worse case."

Other fund managers, including Steve Cohen, whose longtime hedge fund, SAC Capital, recently transitioned into a privately held family office called Point72, have spent much of this year expecting a significant letdown in the stock market. Whether that's occurring at the moment, of course, remains to be seen.