Junk bonds are an unnoticed source of stock market information.

Companies that are at a certain level of risk of bankruptcy, issue unnecessary bonds, they are high-yielding. The yield on unnecessary bonds is much higher (and riskier) than the yield on treasury securities.

High-yield bonds are also volatile.

Because investors holding bonds can lose everything if the issuing company goes bankrupt, concerned traders tend to sell quickly. Similarly, because bonds yield high yields, traders buy at a faster rate if they are confident that the risks are low.

This rapid buying and selling makes unnecessary bonds a useful indicator of the stock market. We can even develop complete trading strategies based on their profitability.

How Unnecessary Bonds Affect Stocks

The simplest strategy for unnecessary bonds is to sell stocks and keep cash if the yield is too high. The diagram below shows how the SPDR S&P 500 ETF (NYSE: spy) reached when the yield on unnecessary bonds was more than 10%, as now.

High unwanted returns cause stock sales

This chart uses the ICE BofA CCC & Lower US High Yield Index Option-Adjusted Spread (OAS). You don’t need to calculate OAS or even know what OAS is. The Federal Reserve provides data here.

Most of the time, when the yield is 10%, the shares sell out. This happened during all three bear markets at 21^street century. The picture gets even worse as the yield on unnecessary bonds grows.

Yields on unnecessary bonds will almost certainly increase if the Federal Reserve raises rates. The Fed’s actions make it difficult for financially shaky companies to secure funding for their operations. This will push the first high-risk bond companies to bankruptcy.

Now is the perfect time to prepare for this.

Result: Avoiding the stock market at such times beats the “buy and hold” strategy.

You can also buy put options on iShares iBoxx $ High Yield Corporate Bond ETF (NYSE: HYG). Put options increase in price as prices fall, and bond prices fall as yields rise.

Michael Carrthere is editor c True Options Masters, One Trade, Peak Velocity TraderandProfit accuracy. He teaches technical analysis and quantitative technical analysis at the New York Institute of Finance. Follow him on Twitter@MichaelCarrGuru.

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