bl>S&P 500 Cheapest to Junk Bonds Since ‘07 Signals Gain
By Lynn Thomasson and Bryan Keogh
March 29 (Bloomberg) -- The Standard & Poor’s 500 Index is trading at the lowest valuation compared with junk bonds in two years, a sign the stock-market rally will continue, if two decades of history are any guide.
The lowest-rated debt pays 3.22 percentage points more than the earnings yield on the S&P 500, the smallest gap since 2007 and a discount to the average 5.93 points of the past 22 years, data compiled by Bloomberg show. The measure of profits compared with share prices shows stocks may be undervalued next to the fixed-income investments most closely correlated with equities.
ING Investment Management, Leuthold Group LLC and RBC Wealth Management are buying shares on speculation the relationship will return to normal. While equities and bonds rose in 2009, the 58 percent surge in Merrill’s U.S. High Yield Master II Index exceeded the 26 percent gain in the S&P 500 by the biggest margin since the debt measure started in 1986.
“If I had to pick one, it would probably be equity,” said Paul Zemsky, the New York-based head of asset allocation for ING, which oversees $550 billion. “There’s no reason equities can’t keep going up for several years to come, whereas there’s a lower boundary to credit spreads. I don’t think we’re going back to the kind of spreads we had in early 2007.”
Gauge of Bonds
The Merrill gauge of bonds rated below Baa3 by Moody’s Investors Service has returned 82 percent since bottoming in December 2008. That compares with a 37 percent gain over the same period for the S&P 500, including a 76 percent rally since March, the biggest in seven decades. Futures on the S&P 500 expiring in June rose 0.4 percent at 8:50 a.m. in London.
High-yield credit spreads, or the extra yield demanded by investors to compensate for default risk, have shrunk to an average of 5.8 percentage points from a peak of 21.8 points, data compiled by Merrill show.
Stockholders of Dean Foods Co., Pulte Group Inc. and SandRidge Energy Inc. are speculating shares will rebound after trailing their own debt as the economy bottomed.
Junk bonds of Dallas-based Dean, the biggest U.S. dairy processor, returned 27 percentage points more than its equity during the past year. The shares advanced 35 points more than bonds during the bull market that ended three years ago, data from Bloomberg and Trace show.
Moved Together
Buyers of junk debt and stocks assume the greatest risk should a company default and the securities have historically moved together. The S&P 500 posted an average annual return of 11 percent since 1987, compared with a 9.7 percent gain in junk debt, data compiled by Merrill Lynch and Bloomberg show. U.S. shares climbed 0.6 percent last week, compared with a 0.3 percent rise in the bond gauge.
“It’s hard to get a compensating return for the risk you take in the bond market, yet people are still doing it,” said Philip Dow, the Minneapolis-based director of equity strategy at RBC Wealth, which oversees $164 billion. “There’s a pretty good chance we’re going to have a global synchronized recovery, and the best way to participate is by buying equities.”
The benchmark index for U.S. shares would be 18 percent higher at 1,380 had it advanced as much as speculative-grade spreads narrowed since December 2008, according to Leuthold Group, whose $1.5 billion Leuthold Core Investment Fund has beaten 96 percent of its peers in the past five years. The firm cut its stake in junk bonds to 4 percent from 12 percent in 2009, according to spokesman Glenn Larson. Its allocation funds have 64 percent in shares.
New Normal
Bill Gross, manager of the world’s biggest fixed-income fund at Pacific Investment Management Co., said “bonds have seen their best days” after the yield on 10-year Treasury notes climbed to 3.85 percent last week from 3.18 percent in October. He’s less optimistic than Zemsky and Leuthold on equities, saying valuations show the S&P 500 may return 5 percent to 6 percent on average, the same as junk debt.
“Flip a coin and take your pick,” said Gross, whose Newport Beach, California-based firm said in December it will offer equity funds. “It’s not about whether high yield will do 1 percent better than stocks, but they’re both in a 5 to 6 percent category, and that’s not what investors are used to.”
The S&P 500’s earnings yield, the inverse of its price- earnings ratio, is 5.34 percent, Bloomberg data show. High-yield bonds pay out 8.57 percent on average, according to data from Charlotte, North Carolina-based Bank of America Corp.’s Merrill Lynch unit.
Budget Deficits
Gains in equity prices may not be sustainable, says John Lynch, chief market strategist at Evergreen Investments, which oversees $155.5 billion. He predicts the S&P 500 may climb 5 percent in the next few months and then fall as much as 20 percent as budget deficits around the world curb growth.
“We’re going to have these credit issues creeping into and fracturing the sentiment of investors for the next couple years at least,” Lynch said in an interview from New York. “This is going to be death by a thousand cuts because we have a variety of issues that could surface.”
The S&P 500 fell the most in a month on March 24 after Fitch Ratings cut Portugal’s credit grade for the first time to AA- with a “negative” outlook amid concern Europe’s weakest economies will struggle to meet debt commitments. Paul Donovan, the deputy head of global economics at Zurich-based UBS AG, told Bloomberg Radio that Greece will eventually default.
Record Yields
Investors piled into fixed-income securities after the financial crisis forced borrowers to pay record yields and stocks posted the worst losses since the 1930s. More than $450 billion has been added to bond funds since the end of 2008, compared with $13.6 billion in equity funds, according to data compiled by the Investment Company Institute, the Washington- based trade group.
Funds buying speculative-grade debt took in a record $33.6 billion this quarter, according to EPFR Global, a research firm based in Cambridge, Massachusetts. Investors withdrew $13.2 billion from U.S. stock funds.
Dean Foods shares slumped 16 percent to $15.67 over the past year on concern inflation in raw milk will reduce earnings. The company’s 7 percent notes due in 2016 returned 11 percent over the period, based on Trace prices compiled by Bloomberg.
Pulte’s 6.5 percent notes due in 2016 paid 32 percent since April, compared with a 14 percent advance by shares of the largest U.S. homebuilder, which is based in Bloomfield, Michigan. SandRidge’s 8 percent notes due 2018 returned 41 percent in the past year, while stock of the Oklahoma City-based oil and natural gas producer gained 2.5 percent.
“This could be one of those times it makes sense to make some serious commitments to stocks,” said Dow of RBC Wealth. “You get a pretty good bang for your buck.”
To contact the reporters on this story: Lynn Thomasson in New York at lthomasson@bloomberg.net; Bryan Keogh in London at bkeogh4@bloomberg.net.
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