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


  1. Jake - fascinating and nicely done. Would you care to speculate/explain the mechanism that seems to drive this relationship for we slower minds?

  2. slower minds my ass. it takes me hours to fully understand just one of your great articles!

    to me the relationship's mechanism is related to what equity truly is, levered credit. for a given company, they have the option to raise capital in one of many forms; for now lets go with issue debt or issue equity shares.

    if a company only issues equity, their capital structure is simply 100% equity and all earnings of the firm go to equity holders. as long as the company has any value, the equity has a similar value.

    as they issue debt, the equity holders get less of the earnings (a fixed or floating amount goes to the debt holders), but the issuance of debt allows less equity holders to "own" the firm so each get a larger share of those smaller earnings.

    when debt is issued, it is no longer enough for the company to have positive value. they must now have positive value is excess of the debt. in addition, as we learned this past cycle, they must also have liquidity to pay back the bondholders.

    the risk to the bondholders is the company won't be able to pay them back, BUT if they still have a claim (in most cases) to the company and their assets.

    with this in place, we can now see the value in each. the equity acts as a buffer to the debtholders. the higher the value of equity, the more buffer that you will get paid back or that if they miss payments, that the company has actual value.

    when that equity buffer decreases (as the value of the firm decreases), the value of the 'bankruptcy' option becomes smaller in value and more likely. at this point, spreads narrow.

    likewise, when the value of the firm decreases (possibly due to earnings power) then the company is less likely to be able to pay back bondholders, in which case equity values decrease as the probability of equity = 0 increases

    the same people that own the debt, own the equity. think large pension plans and other institutions. when equities sell off, they are more likely to sell the corresponding debt (i.e. rebalance) to buy equity. this puts selling pressure on the price of debt. when investors are levered (think hedge funds) and there is forced selling across assets, this exacerbates the problem.

  3. Thanks and thanks. Hopefully the mental agony is repaid by some usable insights and tools?
    Speaking of which this'll take me a little to think thru. Intellectually I get it but don't quite grasp it yet as in instinctive (think gut-level)comprehension.
    That may have something to do with a little too much wine last night :)
    Bottomline - I'll be back.

  4. Not only were HY bonds severely underpriced (more than equities) and offering equity-like returns for an asset higher on the capital structure, the S&P is also suffering (relatively speaking) under the weight of a large amount of capital raisings. So is it really a surprise that HY bonds outperformed? The same 'phenomenon has occurred with respect to correlation to CDS spreads.

    For the record, I'm with Gross and Grantham on risk assets....break lower.