Junk bonds (X) 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.
Speculative-grade debt has beaten the Standard & Poor’s 500 Index (SPX) by 53 percentage points since October 2007, as the bonds returned 34 percent and the benchmark measure for U.S. equity fell 19 percent, according to data compiled by Barclays Plc and Bloomberg. Investors who held junk-rated bonds of Ford Motor Co. (F) earned seven times as much as shareholders, while debt from Sprint (S) Nextel Corp. and J.C. Penney Co. beat their stocks.
The widening gap shows equity investors are growing more concerned that the sluggish economy will hurt profits even though the debt market doesn’t anticipate a jump in defaults or a new recession. Bears say it’s only a matter of time before earnings decline as manufacturing slows from China to Germany, Europe’s debt crisis worsens and the U.S. jobless rate remains stuck near 9 percent.
“Earnings are already at fairly high levels and to sustain continued earnings growth from here we still need to see reasonably good economic growth,” Jeremy Zirin, who helps oversee $715 billion as New York-based chief U.S. equity strategist at UBS Wealth Management Americas, said in a telephone interview on Nov. 23. “The bond market doesn’t believe we will have a meaningful increase in default rates.”
The trailing 12-month speculative-grade default rate will rise to 3.1 percent by September 2012, below the long-term average of 4.59 percent, New York-based S&P said this month. The rate was 1.94 percent at the end of September.
Analysts’ estimates show earnings at S&P 500 companies will climb 10 percent to $109.04 a share in 2012, according to data compiled by Bloomberg. The profit projection for next year has been cut by 4.2 percent since Aug. 4. Estimates imply 17 percent growth for 2011, down from 20 percent in June. The S&P 500 rose 2.9 percent to 1,192.55 today.
Stocks in the S&P 500 trade at 12.2 times reported earnings. Before the financial crisis in 2008, the valuation hadn’t been that low since 1989, data compiled by Bloomberg show. Yields on speculative-grade bonds, rated below Baa3 by Moody’s Investors Service and BBB- by S&P, average 6.73 percent, compared with 1.96 percent on benchmark 10-year Treasuries. Their spread reached 5.10 percentage points in September, the widest since 2003, the data show.
“Investors are looking at both asset classes and seeing supportive valuations,” Chris Sheldon, New York-based chief investment officer at Dreyfus Corp., which oversees about $450 billion, said in a telephone interview on Nov. 23. “But investors are judging the risk in high-yield to be more fine lined or more understandable,” he said. “The equity risk premium is quite high.”
Mutual fund clients added about $11.2 billion to high-yield bonds this year through Nov. 16, according to Cambridge, Massachusetts-based research firm EPFR Global. They pulled about $49.8 billion out of U.S. equity funds, the data show.
The S&P 500 fell 4.7 percent last week, while the Barclays Capital U.S. Corporate High Yield Total Return Index lost 1.3 percent. A preliminary purchasing managers’ index from HSBC Holdings Plc and Markit Economics showed Chinese manufacturing may contract this month by the most in almost three years.
Germany failed to get bids for 35 percent of the 10-year bonds offered for sale on Nov. 23, propelling borrowing costs in Europe higher and the euro lower on concern the region’s debt crisis is driving away investors. More than $1.2 trillion has been erased from U.S. stock market values since Nov. 15, data compiled by Bloomberg show.
The relationship between the S&P 500 and London-based Barclays’ high-yield index has strengthened. The so-called correlation coefficient that measures their link has increased to 0.86 from 0.26 in August, according to data compiled by Bloomberg. A reading of 1 means two assets rise and fall in tandem and minus 1 indicates they move in opposite directions.
The S&P 500 has returned 81 percent including dividends since March 9, 2009, compared with the 87 percent return from high-yield debt, as measured by the Barclays index.
“When the global economy goes to extremes, investments that are the most economically sensitive begin to act very similar,” Burt White, who helps oversee about $315 billion as chief investment officer at LPL Financial Corp. in Boston, said in a Nov. 22 phone interview. His firm invests in equities and high-yield bonds. “All these default concerns, be it at the country level, at the consumer level or at the corporate level, have all bubbled to the top to one big concern about debt.”
The performance is a reversal of the typical returns because investors usually demand better performance from riskier assets and stockholders are below junk-bond investors in case a company defaults.
Stocks beat junk bonds in the four years before October 2007, when the S&P 500 reached a record 1,565.15. The benchmark index jumped 62 percent including dividends during that time, compared with a 39 percent return for speculative-grade debt. The S&P 500 surged 432 percent during the 1990s, more than double the bond return.
Ford’s 7.125 percent notes due 2025 have risen 129 percent since Oct. 9, 2007, topping the 17 percent gain by shares of the second-biggest U.S. automaker, according to data compiled by Bloomberg. Moody’s and S&P raised Dearborn, Michigan-based Ford to the highest non-investment grade last month.
Bonds Versus Stocks
Sprint has $6.26 billion of junk bonds coming due over the next two years, data compiled by Bloomberg show. The Overland Park, Kansas-based company’s 6 percent notes due 2016 have returned about 10 percent since Oct. 9, 2007, versus an 87 percent drop for shares (JCP) of the third-largest U.S. wireless carrier.
J.C. Penney shares have lost 51 percent since Oct. 9, 2007, versus a 35 percent return on the Plano, Texas-based company’s 7.95 percent securities due April 2017. The third-largest U.S. department-store chain posted its first loss in two years last quarter amid declining revenue.
U.S. Steel Corp.’s 6.05 percent bonds due 2017 have gained about 25 percent, compared with a 78 percent plunge in the shares. The Pittsburgh-based company that makes flat-rolled steel for use in autos and appliances posted a third-quarter profit that exceeded analysts’ estimates.
Stocks are cheap compared with credit. Junk debt offers an average yield of 6.73 percent, compared with an earnings yield of 8.21 percent for the S&P 500, data compiled by Bloomberg show. The gap reached 1.86 percentage points in October, the most ever except for the six months after Lehman Brothers Holdings Inc. fell in 2008.
“Equities hands down,” Jeffrey Saut, chief investment strategist at Raymond James & Associates in St. Petersburg, Florida, said in a telephone interview on Nov. 22. His firm manages $300 billion. “I have no interest in fixed income at this point of the cycle. I’m in a camp that we’re not going into a recession.”
To contact the reporters on this story: Nikolaj Gammeltoft in New York at firstname.lastname@example.org; Lu Wang in New York at email@example.com; Lynn Thomasson in Hong Kong at firstname.lastname@example.org