If you really think about it, Fed Chairman Ben Bernanke has this Clark Kent thing going on. By night, he is a soft-spoken family man, more blue collar than blue blood—an academic who carries a Jos. A. Bank charge card. By day, he flexes monetary superpowers, including the ability to conjure up trillions of dollars to buy Treasuries and mortgages.
One thing SuperFed can’t do—at least not directly—is goose the economy and popular confidence by buying stocks. It can, however, do this transitively, by inducing what Wall Street likes to call a “pain trade”—forcing investors out of the perceived safety of risk-lite Treasuries. Then, if all goes as planned, they will find themselves maxing opportunity out of yield-sapped corporate bonds, including higher-risk junk bonds. Bernanke, you see, is making investors grovel for return. And if they grovel long enough, they are bound to finally make that capital-structure leap of faith to the stock market. Retirement-account values will go up. Companies will have more valuable currency with which to make acquisitions. Hiring and consumption could well take heart.
Fifteen years after Bernanke’s predecessor Alan Greenspan famously warned of irrational exuberance in markets, the long-awaited great migration back to equities (following the 2000s’ two growling bear markets) has yet to happen. But if things continue apace, and Bernanke keeps doing what he’s doing, it could take hold any day now.
“We’ve come from financial depths that none of us have ever seen,” says Meg Green, chief executive officer of Meg Green & Associates, an Aventura (Fla.) wealth manager. “As night follows day, though, there’s light at the end of the tunnel. Riding the market waves should become second nature, letting longer-term portfolios travel on an upward trend.”
In the meantime, it’s been all fixed-income, all the time. (Not that stocks have been banished to Vladivostok. The Standard & Poor’s 500-stock index is up 14 percent so far this year, and has more than doubled off its financial-crisis low.) Investors have plowed just under half a trillion dollars into bond funds this year, according to EPFR Global. Thanks in large part to record-low borrowing costs brought on by the largesse of the Federal Reserve and its overseas counterparts, the bond market is putting the finishing brushes on an all-you-can-eat year. Corporate bond sales from the U.S. to Europe and Asia have crossed 2009’s record to reach $3.89 trillion, up from $3.29 trillion last year and $3.23 trillion in 2010, according to data compiled by Bloomberg. In the U.S. alone, issuance also set a record, hitting $1.45 trillion, compared with $1.13 trillion last year.
Amid that feeding frenzy, the extra yield investors demand to own corporate bonds over Treasuries is at a mere 2.23 percentage points, compared with 3.51 at the end of last year, according to Bank of America Merrill Lynch’s Global Corporate & High Yield index. “Junk” is no longer a pejorative.
As the corporate bond market gets its dregs scraped, repeatedly, Wall Street’s capacity to transact the stuff is being strained. An average of $16.93 billion of investment-grade and high-yield bonds traded every day this year, while the value of outstanding corporate bonds rose to $5.72 trillion. Last year’s average daily trading volume of $15.73 billion occurred amid $4.86 trillion of debt outstanding.
Mark Freeman, chief investment officer of Westwood Holdings Group in Dallas, thinks this pigout is primed to relocate to equity markets, which have yet to revisit their records. “A group of investors, which I refer to as ‘bond market refugees,’ have to find a new home in order to meet their income needs,” he says. To underscore how crowded a trade he believes bonds have become, Freeman highlights that the investment-grade universe trades at a price-earnings multiple of 58, while junk bonds change hands at 16 times earnings. He says that “if corporate earnings can show any growth at all next year, which I believe they will, it is very unlikely the Standard & Poor’s 500 index will continue to trade at a p/e of 13, especially given that it has a higher yield and the potential for earnings growth—something bonds cannot offer.” Of the emerging risk-reward calculus, Freeman says: “Given the current environment, bond investors will eventually find high-quality, dividend-paying stocks as an attractive alternative.”
The question is, can the Fed pain trade last long enough—and without a shock that’s out of its control—to push investors en masse into the stock market. For all Bernanke’s superpowers, he’s not omnipotent.
In a Dec. 17 report entitled The “Bond Bubble”: Risks and Mitigants, Fitch Ratings noted that if interest rates were to revert rapidly to early-2011 levels, a typical, 10-year investment-grade corporate bond could lose 15 percent of its market value, while a 30-year equivalent would take a 26 percent hit.
Such a blindsiding—you can actually lose money in bonds?—would spoil the long-awaited rapprochement with equities.