Monday, October 26, 2009

On the Relationship Between High Yield and Equities

Bloomberg details the outperformance of high yield relative to equities:

The worst performance by U.S. stocks compared with junk bonds since at least 1986 is making investors even more bullish on equities.
While owning debt in the riskiest companies has paid about the same as the Standard & Poor’s 500 Index over the last 23 years, bonds are returning more than twice as much in 2009, according to data compiled by Merrill Lynch & Co. and Bloomberg. When high-yield credit beat the S&P 500 by 32 percentage points in the 12 months ending March 11, 2003, stock gains exceeded bonds by 19 percentage points for the rest of the year.

Bonds rated below Baa3 by Moody’s Investors Service and BBB- at S&P are returning more after the worst recession in 70 years spurred purchases of securities that wouldn’t be erased in a bankruptcy. They rose faster than stocks as companies in the S&P 500 reported two years of declining earnings, the longest stretch since the Great Depression.
“There was a flight up the capital structure that swelled the interest in high-yield bonds,” said Kevin Starke, a CRT Capital Group analyst in Stamford, Connecticut. “Why own the equity of a company, which is almost a guaranteed wipeout in most bankruptcies, when you could own the bonds and have a shot at a recovery and still have an equity-like return?”
While the performance of each has diverged, the relationship has not. The chart below details the change in the S&P 500 (in points) against the spread of those bonds rated BB, to Treasuries (inversed). When the spread narrows and high yield outperforms, so does the S&P 500.

The big difference this year was the massive amount of income high yield was generating at lows (at one point reaching ~20% above Treasuries vs. the 2-3% dividend yield spit out by equities).

Source: Barclays