Junk bonds are poised to extend their lead over U.S. equities into a fifth year as debt investors bet that the American economy will keep expanding even if profit growth slows. Bonds rated below investment grade have beaten the Standard & Poor’s 500-stock index by 53 percentage points since October 2007, returning 34 percent through Nov. 25, while stocks fell 19 percent, according to data compiled by Barclays (BCS) and Bloomberg.
The contrast is even more striking in the case of several well-known companies. Ford Motor’s (F) 7.125 percent notes due in 2025 have risen 129 percent since Oct. 9, 2007, well ahead of the 17 percent gain by shares of the second-biggest U.S. automaker, according to data compiled by Bloomberg. Moody’s Investors Service (MCO) and S&P (MHP) raised Ford to the highest noninvestment grade in October. Sprint Nextel’s (S) 6 percent notes due in 2016 have returned about 10 percent since Oct. 9, 2007, vs. an 87 percent drop for shares of the third-largest U.S. wireless carrier. J.C. Penney shares have lost 51 percent since Oct. 9, 2007, while its 7.95 percent securities due in April 2017 have returned 35 percent.
Stocks are lagging because investors are concerned that the sluggish economy will hurt profits. “Earnings are already at fairly high levels, and to sustain continued earnings growth from here we still need to see reasonably good economic growth,” says Jeremy A. Zirin, chief U.S. equity strategist at UBS Wealth Management Americas (UBS). Junk bonds have remained buoyant because “the bond market doesn’t believe we will have a meaningful increase in default rates,” he says. The default rate on speculative-grade bonds was 1.94 percent over the 12 months through September, well below the long-term average of 4.59 percent. S&P predicts the rate will rise to 3.1 percent for the 12 months ending next September.
Junk bonds offer higher yields than safer alternatives. Yields on speculative-grade bonds, rated below Baa3 by Moody’s and BBB- by S&P, average 6.73 percent, compared with 1.96 percent on 10-year Treasuries. While equities may look like bargains, mutual fund investors are making their preference clear. They added about $11.2 billion to high-yield bond funds this year through Nov. 16, according to research firm EPFR Global, while pulling about $49.8 billion out of U.S. equity funds.