The problem with junk bonds is way bigger than oil

The troubles in the high-yield bond market have been closely linked to crude oil's slide. But this conventional wisdom doesn't withstand a peek under the hood of the most popular way to play so-called junk bonds.

Taking the popular iShares high-yield ETF (HYG) as a proxy for the space, one finds that there just isn't a gigantic amount of energy bonds contained therein. The energy sector's weighting in the ETF is only 11.4 percent. That makes energy the fourth-most-prominent sector in the product; communications is No. 1, with more than double the weighting.

In terms of simple numbers, only 16.4 percent of the bonds in the sector are energy bonds.

Given this mild allocation, one wouldn't expect the ETF to track energy stocks — and it really doesn't. Over the past five years, the HYG's daily correlation with SPDR's popular energy sector ETF (XLE) is 0.66.

Correlations run from -1 to 1, with 1 representing perfect correlation, so 0.66 may appear to be a tight relationship. However, the high-yield ETF's correlation to the overall S&P 500 is 0.73.

This means that if one wanted to predict how the HYG traded in a given day, one would be better off consulting the S&P than the energy sector alone.

Granted, the relationship between crude oil and high-yield bonds has been rising. Over the past five years, the correlation runs at 0.31; in the past year, that has risen to 0.36. Presumably, high-yield bonds are being viewed as increasingly sensitive to crude oil, given the potential for defaults among companies exposed to oil moves.

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However, this is still far from the main way that high-yield bonds are currently viewed. Mostly, they are treated as an extension of stocks; a way for those bullish on the overall market or economy to generate additional yield.

There's a widespread feeling that "the economy is OK, and therefore high yielding in general should be OK," Bank of America Merrill Lynch head of high-yield strategy Michael Contopoulos said Friday on CNBC's "Fast Money."

But "it's not just a commodity story," Contopoulos continued. "Leverage in noncommodity high yield is the highest it's ever been. So although corporate America as a whole and the consumer balance sheet is fairly healthy, high-yield companies' balance sheets are not that healthy — even outside of commodities."

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Given the peas-in-a-pod relationship between mega-cap stocks and junk bonds, the real question is whether stock investors will begin to see the recent plunge in high-yield bond funds like the HYG as a sign to sell equities.

On Friday, the HYG and S&P 500 both plunged 2 percent, as high-yield fund Third Avenue moved to liquidate its assets. But on Monday, as the high-yield carnage continues, stocks are managing to hold up.

The ongoing strength of the relationship between these two sets of risky assets may hold the key to the market's next move.


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Trading Nation is a multimedia financial news program that shows investors and traders how to use the news of the day to their advantage. This is where experts from across the financial world – including macro strategists, technical analysts, stock-pickers, and traders who specialize in options, currencies, and fixed income – come together to find the best ways to capitalize on recent developments in the market. Trading Nation: Where headlines become opportunities.

Michael Santoli

Michael Santoli joined CNBC in October 2015 as a Senior Markets Commentator, based at the network's Global Headquarters in Englewood Cliffs, N.J.  Santoli brings his extensive markets expertise to CNBC's Business Day programming, with a regular appearance on CNBC's “Closing Bell (M-F, 3PM-5PM ET).   In addition, he contributes to CNBCand CNBC PRO, writing regular articles and creating original digital videos.

Previously, Santoli was a Senior Columnist at Yahoo Finance, where he wrote analysis and commentary on the stock market, corporate news and the economy. He also appeared on Yahoo Finance video programs, where he offered insights on the most important business stories of the day, and was a regular contributor to CNBC and other networks.

Follow Michael Santoli on Twitter @michaelsantoli

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