Valuation Matters.... Equity vs Bonds Edition

I've shown that valuation matters numerous times over the years when it comes to long-term equity returns (see here, here, and here for some of my favorite examples). The below post uses the same concept in that it compares valuation (i.e. yields) with forward returns, but in this version we compare the relative performance of equities vs. bonds.

The first chart shows the factor that serves as our starting point for valuation... earnings yield of the S&P composite (i.e. the inverse of the P/E ratio) and the yield of the ten year Treasury bond going back 100 years. What we see is a relationship between the two starting about 50 years ago that was non-existent the previous 50 (and the recent divergence that is the widest in almost 40 years).

But the lack of a relationship from 1912-1962 doesn't mean it the relationship wasn't always important. The next chart outlines the forward ten year return differential (annualized) for each starting point against the starting excess yield (the equity earnings yield less the bond yield). Interesting to note that we can easily see the unwarranted excess return that equities saw over bonds starting in the 1980's (i.e. the equity bubble), that was given back over the past ten or so years.

To summarize the above, the next chart outlines the forward ten year return differential (annualized) for each starting point by "bucket" (note that at current valuations we just made it into the 5-7.5% bucket, hence the yellow highlight). The takeaway is that starting yield differentials matter... a lot. To be more specific, the current 5-7.5% bucket means that for every period over the past 100 years when the yield differential was between 5-7.5%, the average annualized ten year forward return differential was a bit more than 8% (8% over the current 1.5% ten year would be 9.5% absolute returns for equities).

While I refuse to state that returns will be anywhere near this 9.5%, by almost all measures stocks appear cheap on a relative basis to Treasury bonds. Unless earnings collapse back to a "normal" percent of the overall economic pie abruptly (definitely possible, but in my view not likely) or the economic pie contracts abruptly, stocks are going to outperform bonds over the next ten years.

Source: Irrational Exuberance

Dividend vs. Treasury Yields

The dividend yield of the S&P 500 is above that of the ten year Treasury for the first time since the financial crisis. Before that we have to go all the way back to the 1950's to find a time when this was the case.

The kicker... stock dividends have only made up about 45% of total S&P composite stock returns over the past 100 years, while Treasury bond coupon payments have made up north of 96% of Treasury bonds returns over that same period (see below). What this means for an investor is unless you think dividends will be cut and/or capital appreciation will be negative (i.e. corporate America will shrink in terms of nominal value), stocks are poised to outperform.

My take... stocks appear to be very cheap relative to bonds for investors with a long-term investment horizon, while near term investors need to be careful as we seem to be in a world that is likely to have binary outcomes (i.e. either a boom or an absolute collapse).

The remaining 55% of S&P stock returns have been in the form of capital appreciation, which has become increasingly important since the 1950's (see above), as corporations reinvested earnings back into their businesses / bought back shares (vs paying out dividends), while investors evaluated the relative merits of equities relative to bonds (see the much tighter relationship to bonds, which ratcheted up P/E multiples).

Source: Irrational Exuberance

Stocks for the Long Run?

While the below chart cherry picks one of the best performing fixed income sectors, it is still pretty amazing.

Bonds (defined in this example as the Barclays Capital Long Government / Credit index) have now outperformed stocks (defined as the S&P 500 index) going back to November 1980 (10.7% annualized vs. 10.4% annualized) and has more than doubled the performance of stocks over the past 15 years (239% vs. 108%). Note the chart below is total returns including reinvestment coupon payments and dividends.

Is this likely to continue?

Unless capitalism as we know it ends, the answer is a simple 'no' over the next 15 or 32 (or even 3-5) years. The government / credit index shown above yielded a whopping 13.18% as of November 1980 and the next 32 years were the great bond run that has resulted in the current paltry yield of 3.89% (just 7 bps off its all-time low).

Source: Barclays Capital / S&P

Why Investors are Reaching for Yield?

Because high yield is just about the only place you can get yield within the U.S. without taking on interest rate risk. The question is whether investors know / are comfortable with the credit risk they are taking.

Source: Barclays

Not All Bonds are the Same

The (overrated) bond sell-off took a breather today, perhaps rallying on news that iron ore demand from China was waning.

Regardless of the whether or not the sell-off is just noise (my guess until proven otherwise) or the reversing of what has been a 30 year trend, it's important to remember that not all bonds are the same.

In the face of the "huge" 2.1% Treasury sell-off (kidding) since the Treasury index hit its all-time high on January 31st (yes, all this news of a Treasury sell-off is when the index is 2.1% off its all-time high), we can see that quite a few sectors actually have positive performance over that time.

Source: Barclays Capital

Some More (Ugly) Bond Math

I've come across a number of forecasts for US Bond returns in the 4.5% - 6% range for the next 5 or so years.

Unfortunately, that is very wishful thinking.

The chart below shows that yield to maturity is awfully accurate in predicting five year forward returns for the aggregate bond index (this is because 5 years is roughly the universe of US bonds' duration). The unfortunate part is the current yield to maturity is a measly 2.06% as of today's close.

What does this mean?

It means that investors should not expect more than 2% annualized from your bond allocation over the next five years, UNLESS you are willing to reach for yield via lower quality credit, non-US exposure, or increased duration. It also means that if you have a 60% equity / 40% bond allocation, to reach an 8% all-in annualized return your equity allocation needs to return roughly 12% / year over the next 5 years. In addition, it likely means that correlation between bonds and equities are likely to increase over this time frame during times of turmoil, as bonds don't have room to appreciate in a flight to quality (more on that here).

In other words... don't expect much help from bonds (all that said, 2% still seems compelling relative to my 0% checking account).

Source: Barclays Capital

Bond Math: Duration Risk at the Zero Boundary

There seems to be lots of confusion surrounding Bill Gross' latest Investment Outlook, Life and Death Proposition. First, some background of what Bill Gross stated...

Investors aren't only concerned with credit risk (i.e. the ability to get paid back), but also duration risk (the risk of lending for an extended period of time in fear that rates may rise).

In Bill's words:

What perhaps is not so often recognized is that liquidity can be trapped by the “price” of credit, in addition to its “risk.” Capitalism depends on risk-taking in several forms. Developers, homeowners, entrepreneurs of all shapes and sizes epitomize the riskiness of business building via equity and credit risk extension. But modern capitalism is dependent as well on maturity extension in credit markets. No venture, aside from one financed with 100% owners’ capital, could survive on credit or loans that matured or were callable overnight. Buildings, utilities and homes require 20- and 30-year loan commitments to smooth and justify their returns.

Investors had been willing to take on this duration risk because they would be compensated with additional yield AND (this is important) because bonds could appreciate if rates fell (i.e. when yields fall, bonds rise).

Back to Bill:

Because this is so, lenders require a yield premium, expressed as a positively sloped yield curve, to make the extended loan. A flat yield curve, in contrast, is a disincentive for lenders to lend unless there is sufficient downside room for yields to fall and provide bond market capital gains.

And although the yield curve is steep, it is very low in nominal terms (i.e. there is less room for rates to move down).

Last time to Bill for his main argument:

Even if nodding in agreement, an observer might immediately comment that today’s yield curve is anything but flat and that might be true. Most short to intermediate Treasury yields, however, are dangerously close to the zero-bound which imply little if any room to fall: no margin, no air underneath those bond yields and therefore limited, if any, price appreciation. What incentive does a bank have to buy two-year Treasuries at 20 basis points when they can park overnight reserves with the Fed at 25? What incentives do investment managers or even individual investors have to take price risk with a five-, 10- or 30-year Treasury when there are multiples of downside price risk compared to appreciation? At 75 basis points, a five-year Treasury can only rationally appreciate by two more points, but theoretically can go down by an unlimited amount. Duration risk and flatness at the zero-bound, to make the simple point, can freeze and trap liquidity by convincing investors to hold cash as opposed to extend credit.

Now my oversimplified explanation using two interest rate scenarios...

Scenario one... bonds yielding 5%.

In this scenario, bonds with maturities 1 year through 5 are yielding 5%. Should rates stay at 5%, the bonds are worth PAR (i.e. $100) in all scenarios. However, the bonds have the potential to appreciate should yields move lower. In fact, should rates fall all the way to 1% (a huge decline, but this is meant to illustrate the point), the bonds actually appreciate almost 20% in the case of the 5 year Treasury. Compare that to the one year Treasury that gained less than 5%.

In other words, in a flight to quality scenario there is a HUGE incentive to own the longer duration bond when yields have room to compress.

Scenario two... bonds yielding 1%.

In this scenario, bonds with maturities 1 year through 5 are yielding 1% (yes the yield curve is upward sloping in "real life", but this isn't far off). Should rates stay at 1%, the bonds are again worth PAR (i.e. $100), but in this case they have limited room to move due to the zero boundary. Should rates move all the way to 0%, the five year bonds don't appreciate 20% like in scenario 1, they appreciate only 5%, while the one year Treasury appreciates around 1%.

In other words, in a flight to quality scenario the potential benefit of a longer duration Treasury is 75% lower than in scenario one and only 4% higher than the one year maturity bond.

The example above is close to current rates (as of this writing, a five year bond yields 0.82%). The result, as Bill Gross points out, is a lack of incentive for a lender to lend and take that risk as they can get roughly the same yield just putting their money in a mattress without the risk of rates moving higher (0% isn't far from 0.82%). In addition, for an investor that is allocating to bonds to diversity their equity holdings, fixed income will no longer appreciate in a flight to quality scenario to offset equity losses. As a result, businesses should in theory be having a hard time getting money for their businesses outside of equity financing.

But, the evidence doesn't point to any of this being an issue. As far as I know, investors are still willing to extend the duration of their investments to pick up this incremental yield. And why not? The Fed has made it clear there is zero risk that rates will rise going out to at least 2014. So why not pocket that additional 82 bps regardless of the lack of capital appreciation?

France is No Germany

FT Alphaville details:

The 30-year German bond yield is close to a record low, around 2.48 per cent at pixel time. France might be able to borrow for 30 years at just 4.4 per cent (i.e. hardly a distressed credit)… but the days of convergence are long gone.

End of the Bond Bull Market

Lets take a quick look at the Treasury market over the past 15 years.



Bull run?

Absolutely (i.e. rates have trended down for a long time).

The end of a bull run?

In other words, can you expect capital appreciation to provide returns in excess of the yield? No... so yes, an end of a bull run.

Is Jake an "investor" in Treasuries?

Not at all. I'll detail my current investment strategy another day, but it mainly involves betting against ETF's and ETN's that "attack".

Why?

Jake (a patient investor with no specific benchmark or liabilities) believes he can do better waiting for the next opportunity (even if it means speaking in third person under a pseudonym).

So given all of that... longer duration Treasuries are rich... right?

Not necessarily. As I detailed in Yield Wins in the Long Run, a 2.7% 10 year and 4.03% 30 year yield simply means that investors should expect a nominal return of 2.7% and 4.03% for the duration of that type of investment (currently around 8.5 years for a 10 year Treasury and 17 years for a 30 year Treasury). BUT, as described in the posts On the Value of Treasuries and Investing in a Low Return Environment there is a strong possibility (in my opinion) that these yields may simply reflect a period of stagnant growth and disinflation.

So, a good investment? If there is inflation... heck no. Deflation... heck yes.

Conclusion

Uncertainty and until I have some, I'll be yet again be (mainly) sitting on the sideline.

Source: Federal Reserve

The Low Quality Corporate Bond Rally

The low quality (i.e. high beta) corporate bond rally has continued into 2010...



As a reminder... the SPECTACULAR rally of 2009.

We'll see if this continues. One day is in most cases just noise, but it looks like a high beta sell-off this morning as a flight to quality has sent 10 year Treasuries to 3.54% (down almost 50 bps over the last month).

Source: BarCap

Sell in May... Don't Go Completely Away

There is always lots of "Sell in May, Go Away" chatter this time of year. Marketwatch's Mark Hulbert (via Abnormal Returns) details why:

There are surprisingly strong statistical reasons for "selling in May and going away," many nevertheless find it difficult to actually do what the strategy calls for -- sitting on one's hands from now until Halloween.

It is especially hard to do now, in fact, with the bull market defying all odds and continuing to chug along. Money managers tell me that the worst crime that they can commit, at least in the eyes of many of their clients, is being out of the market when it is rising.

Agreed... and while EconomPic in no way, shape, or form advocates investing in the manner described below, it is interesting none-the-less. Rather than "Sell in May and Go Away", the chart below details the results of the "Secret Sauce" (i.e. Sell S&P 500 in May and then invest in the Long Government / Credit bond index, rather than sit in cash) vs a buy and hold S&P 500 strategy (note that these returns include reinvestment of dividends).



Why does this work?

I have no idea...

Source: S&P / BarCap

Investing in a Low Return Environment... It's All Relative

There seems to be a growing number of articles these days detailing the concern that rising rates will have a dramatic impact on bond performance going forward (see WSJ's The Risk of Rising Interest Rates and the NY Times' Interest Rates Have Nowhere to Go but Up). While I am less certain that rates will in fact rise over the near term (call me a contrarian), I think these articles miss the broader picture and as a result are focusing too much on rising rates rather than the issue facing investors across all asset classes. Specifically, that an investor (unfortunately) is required to take on a much higher level of risk than in the past to get any level of attractive absolute return.

But, since these articles have focused on bonds, lets focus on bonds.

Looking at the Barclays Capital Aggregate Bond Index "BarCap Agg", one of the most widely used benchmarks to represent high-quality investment grade bonds, the chart below shows the yield to worst "YTW" and the duration of the index going back 20 years. As can be seen, these two levels have crossed as the yield of the benchmark continues to ratchet down to historic lows.



Why does this matter? Well if the YTW is less than the duration, that means if interest rates rise across the yield curve by 100 bps (i.e. 1%) or more in the next 12 months, then the yield of the portfolio (i.e. carry) will not make up for the loss an investor realizes from the price impact of rising rates (this ignores convexity, but a duration of 1 roughly means that if rates rise 1%, the portfolio sells off by 1% all else equal).

Lets dive deeper and take a look at the ratio of YTW to duration. At the end of March, the YTW of the BarCap Agg was 3.46%, while the duration was 4.68 years (3.46 / 4.68 = ratio of 0.74). At this point, if rates rise by 74 bps across the entire yield curve, the price impact of the portfolio = -3.46% (-0.74 * 4.68), exactly offsets the yield of the portfolio 3.46%, thus TOTAL returns over a 12 month period would equal zero (again, ignoring convexity).

Below is a historical look at that ratio (we'll call it the Duration Coverage ratio) vs. 12 month forward returns of the BarCap Agg. Interestingly enough, the ratio has closely tracked performance. One thought is that the Duration Coverage ratio shows how much an investor is being compensated for taking risk; when the ratio is low, they are not being compensated much (thus the lower returns on a going forward basis).



So bonds are rich and duration should be avoided at all costs? Hardly.

This type of thinking made sense when one could focus solely on absolute terms. There is no question that an investor is not being compensated much in absolute terms to take on duration risk. But, this should not be a surprise when one considers return expectations for less risky investments. Shown below is the difference between the yield on the ten year and two year Treasury... it is now at historic wide levels (the green line).



As a result, while an investor is not being compensated much to take on duration risk in absolute terms (the ten year yield is low), they are in relative terms as the two year bond was yielding a measly 0.96% at the end of March. The chart below shows the same rolling Duration Coverage as the chart above with one exception... that being the YTW is adjusted by subtracting out the two year Treasury yield to put it in "relative" terms. This changes the story completely. Rather than appearing rich, the relative duration coverage now seems cheap compared to historical levels.



And THAT'S the problem with investing these days (and not just with bonds). With risk-free rates hovering near zero, an investor must take a much larger amount of risk to achieve any level of absolute return. This concept is even more meaningful for an investment in risk assets, such as equities and commodities, as the downside risks of those asset classes are MUCH higher than even the worst case rising rate scenario on an investment in the BarCap Agg.

As a result, the question for all investors should be how comfortable you are taking risk to get a return ON your capital and not just a return OF your capital?

The issue is that a lot of investors don't realize this question needs to be answered.

Source: Federal Reserve / Barclays Capital

High Yield vs. Investment Grade Corporates

As of the end of February, the spread on the investment grade corporate bond index was ~170 bps and the high yield index ~650 bps (up from the 1994-2010 average of 140 bps and 510 bps respectively). Below is a chart of the variance between the two since 1994 (as far back as I was able to pull data).



Below is the relationship between this variance and the subsequent 12 month out/under performance of high yield relative to investment grade corporate bonds. As can be seen, there appears to be a weak relationship between spread variance and performance when spreads are "tight" (in this case less than 600 bps [in blue], where correlation is -0.31), but when spreads were north of 600 bps [in red], correlation spiked to 0.75 (though it is important to note that spreads have only been this wide in two periods and 19 months since 1994 [i.e. small sample set]).



Below is a chart of the above data in a different form broken out by spread "bucket" rather than as a scatter plot. Again, except when spreads were at "world is ending" levels (and the world didn't end), high yield has tended to underperform.



The important point I will make is that any investment in high yield is by definition... risky. Especially at relative "tight" levels coming out of the worst credit crisis since the Great Depression.

Source: Barclays Capital

It's All About the Yield

Here is an easy concept that a lot of people don't seem realize to realize (based upon the number of times I'm asked the question).

What kind of returns can one expect on a going forward basis from a bond portfolio consisting of securities that do not default? Over the life of those bonds the answer is simply the yield of the portfolio.



While volatile as there are a number of components that affect rolling returns (interest rates, spreads, etc...), the chart below gets rid of that noise (and clearly shows the relationship) by showing the three year average of the yield to worst of the Aggregate index and 12 month forward returns.



Simple? Yes. But, a point easily forgotten by investors seeing the most recent 9% 12 month return of the Barclays Aggregate index after the massive rally in interest rates, government purchase of mortgage bonds, and credit rally (all from a starting yield to worst of just 5.3%).

Source: Barclays

Full Circle... Treasuries vs. High Yield

Last week EconomPic recapped the amazing returns high yield bonds have posted to date in 2009 after a tumultuous 2008. Below is a chart of that performance on a monthly basis vs. treasuries.



So, where does that leave high yield and treasury investors cumulatively from the beginning of 2008?

Unbelievably in exactly the same place.



Source: Barclays High Yield / Barclays Treasury Indices

Emerging Market Bonds Roar

Last week we took a look at the stunning rally in corporate bonds. Now lets take a look at Emerging Market bonds. FT Alphaville reports the large flows coming into the asset class:

Investors poured $727m into emerging market bond funds during the week to September 23, the equivalent of 1.3 per cent of these funds’ total assets and the highest inflow since February 2006, EPFR data show.

Global and US bond funds posted their biggest inflows since early 2001, when EPFR first started tracking them.

Funds dedicated to emerging market equities attracted $2.1bn, a 39-week high, which brought the tally for 2009 to $18.2bn. Funds targeted at investments in Europe, the Middle East and Africa attracted $208m; LatAm funds drew $241m and funds targeted at Asia (excluding Japan) attracted $427m.

These flows have resulted in spreads coming in by more than 400 bps since the end of the year, propelling the asset class up more than 30% year to date.



Source: Barclays

Corporate Bonds: From Cheap to Rich

In March I loaded up on both investment grade and high yield bonds (see Are Corporate Bonds a Screaming Buy?) as a long term investment (the key I thought was long term).

Yet by July, I was already beginning to cash out of the positions as I thought they had rebounded too far, too fast. 5% more gains for the investment grade and 20% for the high yield universes gets us to a point where bonds went from CHEAP to what now seems RICH in just about 6 months. Bloomberg details the implications and relative value of bonds to equities:

Stocks offer greater value than bonds and are poised to “catch up” with a rally in corporate debt, according to Rod Smyth, chief investment strategist at Riverfront Investment Group LLC.

The CHART OF THE DAY shows that the difference in yield between corporates and 10-year Treasury notes has narrowed more quickly than the Standard & Poor’s 500 Index has risen since March. The yield comparison is based on a Moody’s Investors Service index of Baa-rated debt. Smyth and colleagues Bill Ryder and Ken Liu had a similar chart in a report yesterday.

Since December, the yield gap has fallen to 2.9 percentage points from a peak of 6.2 points, according to data compiled by Bloomberg. This spread is near its lowest level since January 2008, when the S&P 500 was about 22 percent higher.

“‘Animal spirits’ are returning to Wall Street even if they are still suppressed on Main Street,” the report said. Spreads have narrowed so much that stocks have more room to rise than bonds, especially as earnings increase, it added.

Smyth isn’t the only strategist whose focus has shifted to shares. “Equities no longer look expensive relative to corporate bonds,” Andrew Garthwaite, a global strategist at Credit Suisse AG, wrote in a Sept. 18 report. He downgraded credit, or bonds, based on relative value.

While I am much less than bullish (actually bearish) on equities than those quoted in the article, it is suspicious how far high yield has rebounded in 2009 as compared to equities. While those BBB bonds (as detailed in the article) are now up more than 20% YTD, high yield corporate bonds are now up almost 50%.



Source: Barclays

Help Jake Invest...

Back in March, I posted my belief that corporate bonds were a "Screaming Buy". At that time I liked being able to move up in the capital structure, while still being able to receive an 8%+ yield for investment grade and 20%+ for high yield. I detailed I was:

Invested at a ratio of ~70% investment grade / ~30% high yield via an assortment of close-end funds trading at a discount. For the record I do not shy away from risk, so my recommendation would be to tone down the high yield exposure if you are more risk averse.

Since the time of the posting, the investment grade bond ETF (LQD) has rallied 11% and the high yield ETF (JNK) around 20%.

In other words, in just three short months, much of that opportunity has already gone.



WSJ reported on the topic:

Nine months later, investment grade corporate bonds have recovered from the shock of Lehman Brothers’ implosion.

Spreads had taken quite the ride since spiking at the end of 2008. They soared as high as Spreads soared as high as 656 basis points December 5 before returning 100 basis points.

The chart below shows the absolute yield of the Investment Grade Corporate Bond index, as well as the spread to Treasuries. While this is a great sign for corporations that can again finance their operations at levels seen pre-Lehman (i.e. less than 6%), it obviously makes corporate bonds less appealing to investors.



But how much less?

I am still not excited about the prospect of moving down the capital structure (i.e. to equities), especially after the massive rebound in risk assets. So, if I were forced to invest in either equity OR corporate bonds, I would definitely be going the investment grade route. But fortunately, I am not forced to invest.

Thus, the question becomes are investors being compensated enough (via spread) to invest in investment grade corporate bonds over Treasuries (or other higher quality assets). In other words is the spread to Treasuries attractive enough to take on the extra credit risk?

There is nobody better to get answers from than David Rosenberg. And he notes:

Baa corporate yields are between 50bps and 250bps wider than they were at the depths of the last three recessions, suggesting that there is a lot of “bad” news still priced in.

And...

To be sure, corporate spreads have come in a long way from their nearby crisis highs but looking at prior peaks around major events and economic downturns, it does appear as though there is still a lot of very bad news priced into the sector.

But again, after the massive rebound in "anything risk" over the past few months I am not so certain about valuation. After all the economic data I've walked through daily over the past year on EconomPic, I am not so certain that 50-250 bps of additional spread relative to the last three recessions is enough compensation for borderline junk bonds. After the recent rally in Treasuries, I am not so certain that I even like duration like I did just 2 1/2 weeks ago when the yield on a ten year Treasury was 50 bps higher.

And if there is anything I have learned as an investor, if you are uncertain... GET THE HELL OUT.

For that reason (in my trading account - my 401k is another story), I am no longer long anything except for volatility and cash (I'm guessing long time readers have an idea where I'm short), but I am looking for ideas.

And it's Friday, so PLEASE slack off a bit and provide a few.

Source: Barclays

Corporate Bonds Roaring Back

Source: Barclays

"Mortimer We're Back" Corporate Bond Edition

Well almost back. WSJ with the details:

Nine months later, investment grade corporate bonds have recovered from the shock of Lehman Brothers’ implosion. Investment grade spreads, or the premium demanded over Treasurys of a similar maturity, dropped to 371 basis points Tuesday, according to Merrill Lynch. They hadn’t been that inexpensive since September 15, the first day of trading after Lehman Brothers Holdings Inc. filed for bankruptcy.

Spreads had taken quite the ride since spiking at the end of 2008. They soared as high as Spreads soared as high as 656 basis points December 5 before returning 100 basis points. They briefly rallied to 600 basis points in late March and then plummeted in recent weeks. A basis point is 0.01 percentage points.

Source: BarCap