Junk bonds are giving stocks the green light

The junk bond signal

As stocks reach record highs, the price of speculative bonds have rallied as well, suggesting further gains for equities.

"Typically bonds lead equities," Piper Johnson technical analyst Craig Johnson said Friday on CNBC's "Trading Nation. "

"We've looked at these high-yield indexes in the past, … and what we've found in the past is that it's typically a sign of a risk-on environment for equities. So we do think it's a good sign."

High-yield bonds are more colorfully known as junk bonds, and the two monikers highlight the upside and downside of these fixed income issues. On the one hand, they offer higher yields than most bonds, but their yields are high because their issuers have low credit ratings, meaning there is a greater chance of default.

Such bonds may be viewed as the stocks of the fixed-income world. That's because high-yield bonds, like stocks, generally hope to see better-than-expected economic growth. The difference is that for stocks, economic growth means greater profits, while for high-yield bonds, economic growth means fewer defaults.

The easiest way to examine how high-yield bonds are doing is to pull up the HYG ETF, a popular product from BlackRock's iShares, which tracks a high-yield bond index. On Thursday, the HYG hit its highest levels in over a year.

The performance of high-yield bonds, alongside that of emerging markets and impressive readings on measures of market breadth, led Nautilus Investment Research to conclude in a note Friday that "the current uptrend's health is intact." Translation: More gains look to be ahead for stocks.

Yet for Eddy Elfenbein, editor of the Crossing Wall Street blog, "this doesn't say so much about the stock market right now, but it really reflects what's going on in the oil market."

As he pointed out on "Trading Nation," the correlation between oil and high-yield bond indexes is "very high. … Where oil goes, the high-yield bonds will follow."

The explanation for this: The junk bonds that have looked to be in worse shape have been oil exposed. That means that falling oil prices have made the threat of bankruptcies and consequent defaults look much more likely, forcing high-yield bond investors to keep a close eye on crude.

Of course, stocks are not immune from being driven by the peripeties of the oil market, either.