The recent lower-than-expected non-farm payroll figure indicates that high-yield bonds may be overvalued, said Oleg Melentyev, associate at Merrill Lynch in New York. Historically, spreads and payrolls are highly correlated and the 32,000 new jobs created in July--news of which shocked the capital markets and sent bond prices soaring and the stock market down sharply earlier this month--suggest that the economy will pick up or high-yield spreads will widen. He pointed out that given the tight historical relationship, levels are out of whack and should revert to the norm.
Specifically, the average spread of Merrill's High-Yield Master I Index in May was 418 basis points. Melentyev noted that a more appropriate level given the July jobs report would have been 593bps. Conversely, if the market is appropriately valued, 208,000 new jobs should have been added in July, he said.
May's spreads are compared with July's payrolls because market expectations for payrolls tend to be built in to high-yield spreads two months in advance, he added.
Merrill has been tracking the relationship between high-yield spreads and payrolls since 1985. "If a company is doing well, it has no problem paying its coupons and its salaries. In the opposite situation, if there's a chance that the company will go bankrupt, then it's unlikely they will be hiring," he explained, referring to the correlation between spreads and jobs. "Those two factors have to stay closer than they are, this kind of discrepancy never holds," he added. He said discrepancies have occurred in the past and it is likely the relationship will return to normal.
