Analysts mull junk bond and equity puzzle
By Jenny Wiggins in New York
Published: March 13 2003 23:57 / Last Updated: March 13 2003 23:57
A strong divergence between the performance of US junk bonds and US stocks
has strategists puzzling over the direction the markets will move when they once
again converge.
Junk bonds and stocks typically move in tandem with one another because junk
bonds, like equities, are seen as somewhat speculative investments with little
security.
This year, however, the performance of the markets has diverged sharply. Junk
bonds have returned more than 5 per cent since the start of the year while stocks
have taken losses of more than 6 per cent.
"It's not totally unprecedented that they've diverged," says Martin Fridson, a
high-yield strategist and chief executive of FridsonVision. "But it's unusual."
The last time the markets diverged so sharply was in late 1998, when they were
rocked by Russia's debt default and the collapse of Long Term Capital
Management.
Notable divergences also occurred in 1992 and 1987, according to Christopher
Garman, high-yield strategist at Merrill Lynch.
Analysts attribute the divergence to two key factors. First, large amounts of
money have flowed into junk bond mutual funds over the past three months.
Some $8bn has entered junk funds since the end of November, while more than
$12bn has poured out of equity funds.
Investors have become more enamoured of junk bonds as equity prices and
interest rates have fal len, and it has become more difficult to find assets with
good returns.
News that Warren Buffett, the influential US investor, sharply increased his
holding of junk bonds over the past year has also encouraged demand for junk
bonds.
In Berkshire Hathaway's annual report, Mr Buffett told investors that the
company's commitments to junk bonds "sextupled" in 2002, reaching $8.3bn.
Second, management efforts to repair balance sheets and improve corporate
creditworthiness is benefiting bondholders by lowering the risk of default.
The 12-month average default rate has fallen to 6.9 per cent from a high of 10.2
per cent in April 2002, according to Standard & Poor's.
However, the divergence between the junk bond and stock markets is not
expected to continue indefinitely, and analysts are debating which market will be
the first to adjust. Will the junk bond market decline, or will the equity market
rally?
Merrill Lynch says that when junk bonds perform far better than equities, an
equity market rally typically follows. Research by the bank shows that equities
gain during most of the 90 trading days after periods of large divergence between
the two markets.
But some analysts are sceptical whether the current rally in the junk market can
be sustained. They say that the junk market is drawing strength from technical
factors, such as an overabundance of demand relative to supply.
Close to $20bn in junk debt has been priced this year but the forward calendar
stands at a relatively modest $2.6bn, and new deals could be postponed if the
US goes to war with Iraq.
Michael Taylor, director of high-yield strategy at Bear Stearns, says the
performance of the junk bond market may not reflect the fears over deteriorating
economic growth that have been priced into the equity market. "I'm concerned
that there could be pressure on high yield," Mr Taylor says. "Fundamentally,
there are not many positive signs about growth prospects."
“The things that will destroy us are: politics without principle; pleasure without conscience; wealth without work; knowledge without character; business without morality; science without humanity; and worship without sacrifice.” Mahatma Gandhi
