For the past year, junk bonds (corporate debt that is rated lower than investment grade) have been in rally mode. The iShares High Yield Corporate Bond Fund (HYG) was up 13% from its low last June to its high last month.
Yet the spread between investment-grade bond yields and junk-bond yields is among the lowest in history. Investors aren't getting paid for taking on the extra risk of corporations having a difficult time making payments on their junk bonds when times are tough.
We said junk-bond investors were going to get hurt when reality finally set in and the junk-bond insanity ended. But it was still too early to bet on a decline in the market. Today, junk bonds are starting to break down. And it's time to set yourself up to profit…
Although we said buying junk bonds was a bad bet in May, we also said shorting junk bonds was a bad bet.
HYG had been in a bearish rising-wedge pattern for most of the past year. This pattern develops as a chart makes higher highs and higher lows, but the distance between the highs and lows shrinks. Most of the time, this pattern breaks to the downside. But HYG had just made a new all-time high. And there was still room for HYG to work even higher inside of the wedge.
You see, bouts of insanity can hang on a lot longer than most folks think is possible. So as tempting as it was to try to short junk bonds at their insane levels, the setup wasn't right. It was too early.
It's not too early anymore.
Take a look at this updated chart of HYG…
HYG broke down from the rising-wedge pattern. It also broke below its 50-day moving average (DMA). Most technical analysts view the 50-DMA as the line in the sand separating intermediate-term uptrends from intermediate-term downtrends.
Junk bonds broke below the line last week. The intermediate-term trend is now bearish. And with junk bonds trading at historically high values, there's plenty of room to fall.
Traders should look to short the sector as HYG bounces toward its 50-DMA. Set a stop just above the 50-DMA in order to limit the risk of the trade.
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