A dark corner of the bond market is sending a warning sign about the economy.

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« If our analysis is correct, today’s elevated level of US investment-grade and high-yield credit spreads will persist, and default rates may rise materially through 2016, » UBS’s Stephen Caprio said on Wednesday. « The implication for the US economy is that wide credit spreads and ascending downgrade and default risks will increase borrowing costs for US corporates. This signals a downside growth risk to the US economy. »

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This story is not just about junk bonds. It’s about the junkiest of junk bonds and what they’re predicting for bank lending, which is critical for job creation.

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Let’s take a breath and unpack this for a second.

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What are junk bonds and why are spreads are blowing out?

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Market-watchers have pointed to the recent spike in high-yield bond spreads and noted that this is the kind of move that happens as an economy goes into recession. The high-yield bond market is particularly sensitive to economic cycles. Commonly referred to as junk bonds, these debt securities are issued by companies with low credit quality. Because of the higher risks that come with lending to such companies, they have to offer higher yields than those of their investment-grade peers. When spreads increase, it’s costing more for these junk corporates to borrow.

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« US high yield credit has faced one headwind after the next — from significant distress in Energy, to risks of weakening global growth, to significant uncertainty around Fed rate hikes, » Morgan Stanley’s Adam Richmond said on Friday. « As a result, HY just posted the weakest four-month stretch (Jun-Sep) since the end of 2008, -7.03% in total return. This selloff has driven very negative sentiment, as nothing brings the bears out of hiding more so than low prices, feeding into panicky price action in markets. »

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« The simple point — it doesn’t happen often — only shortly before recessions or during major growth scares, » Richmond said.

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Now, the first caveat everyone points to is high-yield energy, which has been getting slammed by the effects of low oil prices. Indeed, if you take the energy companies out of the picture, spreads in the rest of the junk bond market are much more subdued.
But UBS’s Caprio sees a bit more to the story.

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« This is not just an energy story, but a broader conversation about the credit cycle and our place in it, » he said. The ‘lowest of low quality issuers’ are sending a warning sign

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Caprio thinks we’re heading for a period of tighter, more expensive money. In a note to clients on Wednesday, Caprio observed that what happens in nonbank lending markets like the bond markets lead what happens in bank lending.

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« Our analysis suggests it is actually the lowest of low quality issuers (B-rated and below) that provides the first leading signal that credit stress may lie ahead,  » Caprio wrote. « Worryingly, this chart is flashing red. While BB net issuance has held in quite well, B-rated and lower net issuance has plunged in a replay of late 2007, as investors cut back in the face of growing default risk and rising illiquidity. »
« And stripping out the energy sector from this chart makes no difference; ex-energy low-rated issuance is drying up too, » he added.