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Beware: High-Yield Bonds Warning of a Steep Market Decline

High-yield bonds, less formally known as junk bonds, are an interesting investment. They became popular in the 1980s when they were widely used for corporate takeovers. Investors turned to them when Wall Street firms touted research showing that high-yield bonds outperformed traditional bonds, on average.

"On average" is an interesting phrase because it can be used to hide investment realities. When the research was done, in the 1950s, high-yield bonds were mostly "fallen angels" or companies that had issued bonds when they were healthy and then fallen on hard times. Those high-yield investors were buying bonds in turnarounds.

In the 1980s, high-yield bonds financed unproven businesses and were issued for speculation. This was a classic example of confusing statistics with facts since the new bonds were much different than the ones studied.

Now, high-yield bonds are issued by highly leveraged companies like Dish Network (NASDAQ: DISH) and troubled Ally Financial (OTC: ALFI), which was recently the only large firm to fail the Federal Reserve's stress test. The asset class includes both turnarounds and startups and defies an easy description.

Given the variety of high-yield bonds available, it might not be surprising to see that they trend with the stock market sometimes and act more like bonds at other times. The chart below shows iShares iBoxx $ High Yield Corporate Bond (NYSE: HYG) with SPDR S&P 500 (NYSE: SPY) on the left and with iShares Barclays 20+ Year Treasury Bond (NYSE: TLT) on the right.

High Yield Bond Fund HYG Chart vs SPX, TLT

HYG (the black line in both charts) showed a strong correlation with SPY until early 2011. Since then, stocks have moved higher as HYG moved sideways. While not acting like stocks, HYG is also not acting like a bond investment right now.

It is also important to note that in the bear market that bottomed in 2009, TLT rose while HYG declined. Since 2011, HYG has been forming a large base while both stocks and bonds have seen significant uptrends.

Rather than relying on outdated thinking to understand high-yield bonds, the mistake made in the 1980s, we should consider why investors turned to the investment in recent years. For the most part, instead of thinking of them as stocks or bonds, investors probably view high-yield bonds as a source of income with HYG yielding more than 6.5%.

Most investors realize there is a degree of risk associated with this income and that could explain the topping pattern seen in the chart. Even though HYG is near a 52-week high, relative strength (RS) has completely broken down and indicates HYG is a sell.

High Yield Bond Fund HYG Chart

Momentum of Comparative Strength (MoCS), the indicator shown just below the prices on the chart, has turned negative. MoCS converts RS to a Moving Average Convergence/Divergence (MACD) style indicator with clear buy and sell signals. RS is near 0, the lowest possible value, and has been declining for the past three months.

The 26-week rate of change (ROC) has also been trending lower for months and is in bear market territory as it pushes against its lower Bollinger Band. Testing on other high-yield investments shows that selling short when ROC crosses the lower Band would be profitable. Because HYG has only been trading since 2007, there is only one previous signal, which was a winner, for that ETF.

The weight of the evidence points to a probable decline in HYG. That could be a sign that investors are reducing their risk and a sell-off in stocks, also a risky asset, would be likely to follow.

Options prices confirm a bearish outlook for HYG, which is currently trading at about $94. Calls expiring in January 2014 with a strike price of $95 are trading for about $0.50. Puts with that expiration date and strike price are trading near $7.65. This shows traders believe that nine months from now, HYG is more likely to be below $87.35 than it is to be above $95. RS analysis agrees with them, and stock market investors need to be cautious if HYG is now thought of as a risk asset by investors.

Traders should considering selling HYG and other high-yield bond investments. Puts are too expensive to make a downside bet on HYG and shorting the ETF would be costly because of the dividend payments.