Default risk gets priced in by bond traders

Key points:

• The cost to insure against bond defaults spiked to a 9-month high
• Jumps in the prices for credit default swaps have occurred before some major declines
• The most consistently bothersome sector was energies, which showed weak returns after these signals

Paying up for protection

One of the main drivers of the rise in stock prices this year has been loose financial conditions. That's something of a tautology because stock prices are a portion of most financial condition models, but other inputs carry just as much, if not more, weight.

One of those factors is bond spreads. As spreads widen, showing distress, it feeds into tighter financial conditions. Many of those models show tightening conditions, which have preceded more challenging environments for stocks.

As those concerns rose, traders bought protection against bond defaults. Prices rise when traders scramble for protection, which we can see in the spike in credit default swaps. The chart below shows that the price of CDS protection notched a 9-month high last week (100% of its 189-day range).

When we zoom out, we can see that these signals have been triggered multiple times over the past couple of decades.