Margin Debt Has Soared. It’s a Warning Sign for Markets.

Margin debt has grown by almost 40% year-over-year as of September end. It effectively means investors are borrowing a lot of dollars from their broker to buy shares. (Spencer Platt/Getty Images)

Key Points

• Margin debt increased by 32% to $1.3 trillion over five months through September, a pace suggesting market optimism may be peaking.
• Year-over-year margin debt growth of almost 40% as of September indicates potential risk for investors in high-yield bonds.
• Historically, when margin debt exceeds 40% year-over-year, high-yield spreads have increased by 1.21 percentage points in six months.

Margin debt has soared to a pace not seen since the pandemic, a sign the market’s optimism may be hitting its peak.

Over the past five months through September, margin debt—effectively a loan taken out by an investor from a broker to buy stocks—has climbed by 32% to reach $1.3 trillion.

The only times margin debt increased at a faster pace were the five months ending in August 2020, where margin debt gained by 35%, and five-month periods ending in early 2000s.

Margin debt balances are known to balloon in markets where investors chase momentum, buying at high prices with hopes to sell at even higher levels. The risk is that a stock price drops too much, and the broker asks the client to deposit more money. If the client can’t do that, the broker can sell the clients’ securities to cover the loan. More debt, more risk.

The fast pace of recent gains in margin debt suggest the bullish fervor may have run its course.

“We finally have a tactical euphoria warning signal for the first time in 5 years, and for the first time in 18 years excluding COVID,” wrote credit strategists at Deutsche Bank, led by Steve Caprio. This rally is “now (and only now) suggesting market euphoria is becoming too hot to handle.”

Margin debt has grown by almost 40% year-over-year as of the end of September. This could be bad for investors holding risky assets, specifically junk bonds. More respectfully known as high yield bonds, these are lower-rated debt that have greater default risk.

High-yield bonds appear to be overvalued right now, offering an additional yield of 3.04% relative to ultrasafe Treasuries. This so-called spread has been trending down since 2022’s peak of near 6%.

In the past when margin debt levels have exceeded 40% year-over-year, the median change in high-yield spreads in the six months and year following has been up 1.21 percentage points and up 2.63 percentage points, respectively, according to Dow Jones Market Data.

If spreads gain, prices of high yield bonds will decline, hurting existing investors. Yields and spreads move in opposite direction of prices.

The Covid period of 2020 and 2021 was one exception to the rule. Excessive investor euphoria didn’t ultimately hurt risk assets over the next six to 12 months, Caprio wrote.

But today’s fiscal and monetary picture is completely different, he added. The market is seeing declining banking reserves and the Federal Reserve isn’t pumping money into the market.

“We aren’t going to repeat the resilience,” he concluded.

Write to Karishma Vanjani at karishma.vanjani@dowjones.com.