Ominous Signals Coming From The High Yield Market

Are you prepared for impact? One of my readers alerted me to the fact that someone bought 15,000 January 2016, 80-strike puts on the HYG high yield bond ETF. That’s a $1.6 million cash bet on an event that has not occurred since July 2009.

The high yield bond indices are rolling over quickly.  As the graph below shows, after the QE-driven big bounce from the 2008 collapse in the financial markets, the high yield market has largely drifted sideways since the middle of 2010.   Energy bonds represent about 15% of the high yield market.  But the junk bond market actually began slowly rolling over a full year before the price of oil collapsed:

You see that the junk bond market, as represented by the HYG ETF, peaked in July 2013. The price of oil began to drop like a rock in mid-June 2014. This event didn’t seem to infect the junk bond market until early July 2014.

For a lot of reasons, the high yield market is a lot more sensitive to changes in the financial and economic condition of the system than are stocks. From the graph above, you can see that HYG is down 12.5% from its peak in 2013. At that point in time, the S&P 500 was still on its way to an all-time high. More than half of the 12.5% drop in junk bonds has occurred since the spring of 2015.

The story got a lot more interesting today.  A reader of my blog emailed that someone had bought 15,000 January 2016, 80-strike put options on HYG today (Wed, 9/23).  Here’s the tape – click to enlarge:

Assuming an average price paid for the puts of $1.08, which was the last trade price in the option contract, someone plunked down $1,620,000 to buy puts on HYG with a strike price set at $80. But as you can see from the graph above, HYG has not closed below $80 since July 17, 2009. In fact, it really hasn’t even “sniffed” the low 80’s since late 2011.

In other words, someone pulled $1.6 million out of their pocket to speculate on what, up until now, has been a very low probability occurrence for the last 6 years.

You can see from the graph that if the financial system melts down before the end of the year, and I believe this event is quite possible, HYG could plunge. If it were to do a cliff-dive before mid-January down the the $62 level it hit in early 2009, the value of this put bet will soar to $27 million.

One last note, historically, the big movements in the junk bond market tend to lead big movements in the stock market. If this guy is right on the timing of his bet on the junk market, the stock market will crash before Christmas.

The economic fundamentals are highly supportive of this thesis, at this point it’s only a question of whether or not the monkeys at the Fed are losing their  ability to rig the markets.  I know several market analysts each with decades of experience who think this is the case, including me.