by Pater Tenebrarum, Acting Man:

Junk Bond Spread Breakout
The famous dead parrot is coming back to life… in an unexpected place. With its QE operations, which included inter alia corporate bonds, the ECB has managed to suppress credit spreads in Europe to truly ludicrous levels. From there, the effect propagated through arbitrage to other developed markets. And yes, this does “support the economy” – mainly by triggering an avalanche of capital malinvestment and creating the associated boom conditions, while “investors” (we use the term loosely) pile into ridiculously overvalued bonds that will eventually saddle them with eye-watering losses.

Readers may recall previous discussions of credit spreads in these pages – on a whim we likened the demise of creditor suspicion to the dead Norwegian Blue in the Monty Python sketch. Credit is considered “suspicion asleep”, and the debate in the sketch revolves around whether the bird is merely sleeping or actually dead. Given what has occurred in credit spreads over the past two years, it is not too far-fetched to state that creditor suspicion appears to be dead rather than just asleep.

But we knew it would do the zombie thing and wake up again one day. We refer you to The Coming Resurrection of Polly and An Update on Polly for some background information. In the former we discussed inter alia how credit spreads have behaved in the past in the final stages of a boom and showed numerous charts illustrating what we believed to be quite important points; something traders and investors needed to file under “things to keep a close eye on”.

The points were a) the end comes very suddenly (and hence “unexpectedly”) every time and b) from a technical perspective, all it took on past occasions was a breakout in spreads above the nearest lateral resistance level. A small, barely noticeable breakout, followed by a successful retest – and suddenly spreads would take off into the blue yonder.

This is precisely what has just happened in euro-land, i.e., the global center of spread manipulation by a central planning agency. Behold a classic chart picture:

Junk Bond Spread Breakout

BofA/Merrill Lynch euro area high yield index spread (option-adjusted refers to the to the incorporation of early call options by issuers, which allow them to redeem bonds ahead of schedule). This is a picture-perfect breakout in junk bond spreads. Based on the technical picture, this market is now a screaming short (n.b.: prices move inversely to yields).

Proceed with Caution Anyway
If you are pondering whether you should mortgage the farm, pimp grandma and sell your offspring into slavery to bolster your shorting wherewithal, hold your horses for a moment. As always there are caveats, despite the admittedly enticing technical imagery (coupled with the knowledge that corporate debt has been an accident waiting to happen for quite some time). We do see a potential opportunity here, but one should proceed with caution. Here is why.

Consider that the driving force behind the breakout was a political event, namely the recent election in Italy. We are of two minds about this trigger event. On the one hand, the effects of political news on market action are notorious for their fleeting nature. This is all the more relevant in euro-land, where the eurocracy has proved on numerous occasions that it is able to enforce its diktats, no matter how determined its opposition appears to be.

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