- High-yield stocks down 16% in 2016; investment-grade down 10%
- Yield premium on investment-grade debt highest in 3 1/2 years
For clues as to what’s contributing to the downward force in U.S. stocks this year, take a look at the bond market.
Credit risk has become the byword for vulnerability in 2016’s equity market, as evidenced by the propensity for lower-rated companies to lead the way down -- and not just among commodity producers. Data compiled by Bloomberg shows the division within the Standard & Poor’s 500 Index, where companies with bond ratings below investment grade have lost an average 14 percent year to date, compared with 9.5 percent for higher-rated ones.
Priorities are reversing in a market where for the past three years one of the best things you could do with your money was put it in stocks backed by the weakest balance sheets. Now those stocks are taking the worst of the drubbing as signs of stress multiply in credit markets, oil’s plunge won’t let up and global equities hurdle toward a bear market.
“People are concerned we’re entering a different part of the credit cycle where companies are no longer able to add leverage,” Peter Cecchini, co-head of equities and chief market strategist at Cantor Fitzgerald LP in New York, said by phone. “Equity value becomes much more sensitive as the cushion between leverage on a balance sheet and what equity is worth becomes narrower. There’s a fear credit markets are no longer supporting equity markets.”
A similar story is told by baskets of U.S. companies ranked by Goldman Sachs Group Inc. according to their financial health. Last year, stocks in the bank’s weak balance sheet group trailed their stronger counterparts for the first time since 2011 -- and are down another 10 percent in 2016. The index gained 0.3 percent at 9:40 a.m. in New York.
The yield premium on investment-grade debt has widened 18 basis points to 191 basis points in 2016, the highest in about 3 1/2 years, according to Bank of America Merrill Lynch index data. In junk bonds, spreads have expanded by nearly 100 basis points in January to 788 basis points, hovering at levels not seen since October of 2011.
Even for companies within the investment grade range -- defined as holding a rating of at least triple-B -- losses extend as credit quality worsens. Double-A rated shares in the Russell 3000 Index are down an average 7.8 percent, single-A shares have lost 8 percent and triple-B companies are down 9.9 percent, according to Bloomberg data. Meanwhile, the three companies with coveted triple-A ratings have fallen 7.1 percent.
Think it’s all a function of weakness in energy and mining stocks? Not quite. With those industries removed from the index, the lowest-rated companies are down an average 14 percent in 2016, compared with investment-grade rated companies that have lost 8.5 percent. The trend was evident at the peak of selling Wednesday, when lower-rated companies declined 4.4 percent and higher-quality shares lost 3.7 percent.
BlackRock’s iShares iBoxx High Yield Corporate Bond ETF, the largest ETF of its kind, has declined 4.3 percent in 2016. The SPDR Barclays High Yield Bond ETF has slid 4.8 percent over the same period. Both funds are at the lowest since 2009.
To Barclays Plc, the best way to play the equity selloff is to buy stocks with minimal credit exposure. Since 2000, the 20 percent of S&P 500 companies least reliant on outside funding, defined by the ratio of cash flow from financing activities to market capitalization, have seen returns about double those with the most reliance, according to data compiled by the bank. Companies in the group include Boeing Co., GameStop Corp. and United Rentals Inc.
“Considering that the financing markets have become more constrained, we believe the environment is right for these stocks to continue to work,” Jonathan Glionna, head of U.S. equity strategy at Barclays, wrote in a Jan. 19 client note. “We recommend buying companies that do not need external financing.”
As the selloff in junk-rated equities has worsened, investors are now paying a premium for companies with investment grade ratings relative to their high-yield peers -- the first time that’s happened since 1994, according to data from Bank of America Corp. The forward price-to-earnings ratio for S&P 500 companies with junk ratings slid to 15.3 at the end of December from 16.8 in January 2015. Meanwhile, investment-grade stock valuations climbed to 15.8 times in December.
Already more expensive than its junk counterpart, the group of investment-grade companies may soon be shrinking in size. More companies were at risk of having their credit ratings cut at the end of December than at the close of any other year since 2009, according to Standard & Poor’s.
With the Federal Reserve no longer underpinning the U.S. economy through stimulus injections, some market participants see the reckoning in junk-rated stocks as a shift to a tighter lending regime.
“Credit quality leads, and most of the pain has been focused on high-yield,” Michael Antonelli, an institutional equity sales trader and managing director at Robert W. Baird & Co. in Milwaukee, said by phone. “When you get into these negative feedback loops, the weaker credit gets, the weaker equities get. And when it starts with the risky stuff, it tends to move up the ladder.”