Bond Market: The Search for Yield
05/09/2014 11:45 am EST
As of May 6, junk bond yields are just about even with the earnings yield on the S&P 500 and MoneyShow's Jim Jubak can think of two possibilities as to why.
Judging from the volume of talk, the BIG worry among investors and traders seems to be whether US stocks—trading near all-time highs—are so over-valued that equity markets are in danger of crashing, or smashing, or getting eaten by a bear or something.
Me? I’m much more worried about valuations in the bond market. The search for yield under almost any circumstances has pushed prices of relatively high-risk debt up to seriously worrying levels.
Take a look at junk bonds, for example. These bonds—which earn their name because they come with less than investment grade credit ratings from Standard & Poor’s, Moody’s Investors Service, and the like—are supposed to pay higher yields than relatively less risky bonds such as US Treasuries or German Bunds.
Stands to reason. Even these days, a bond backed by a company with a huge debt load and seriously fluctuating cash flow should pay investors more interest than a bond backed by the very predictable revenue of a national government. (Even if that government is carrying its own big load of debt.)
And junk bonds' yields are supposed to outpace the yields on stocks. Since March 1995, junk bonds have paid an average yield about 4.2 percentage points higher than the earnings yield on the Standard & Poor’s 500 (SPX) stock index. (Don’t confuse “earnings yield” with dividend yield. An earnings yield is the inverse of price to earnings (P/E) ratio. The earnings yield tells you how much in earnings you’re buying for each dollar you pay in the share price. Earnings yield is a measure that lets you compare the stocks and bonds.)
Right now the spread on junk bond yields over 10-year Treasuries is about 3.26 percentage points. (The yield on the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) is 5.85%; the yield on the 10-year Treasury is 2.59%.) That’s narrower than the 3.97 percentage point spread at the end of 2013 and narrower than the historical yield spread over 10-year Treasuries of about 5 percentage points.
But it’s the relationship between junk bond yields and the earnings yield on the S&P 500 that really gets my attention. As of May 6, junk bond yields are just about even with the earnings yield on the S&P 500. (The earnings yield on the S&P 500 is 5.8% and the yield on the iShares iBoxx $ High Yield ETF is 5.85%.)
On the historical record, junk bonds are really expensive in comparison to stocks.
Two possibilities here.
On the one hand, the search for yield may have bid prices of junk bonds up too far, reducing their yield by too much. At worst, this viewpoint says we’re looking for a big slide in junk bond prices—and in the prices of other risky debt—when interest rates start to rise as the Federal Reserve continues to taper off its program of asset purchases. At best, a junk bond yield at the low end of the junk-to-Treasury spread, and that is about equal to the earnings yield on the S&P 500, suggests that investors in junk bonds shouldn’t expect the outsized capital gains going forward that they’ve seen in the last five years. Returns (that’s yield plus capital gains) from junk bonds have averaged 18% annually for the last five years. A more reasonable expectation going forward might be 5%—basically, the interest on the bond without any capital appreciation.
On the other hand, investors in junk bonds may have noticed a default rate well below the historical average for junk bonds and have decided—correctly—that an improving US economy will keep default rates at current low levels. From that point of view, the buyer of a junk bond is getting a big spread over the yield of a Treasury, but without a whole lot more risk. The equity comparison makes sense if the economy is improving and junk bond issuers are the most likely to see leveraged gains from that improvement.
I think it’s possible to make either case and impossible, given the ambiguous nature of recent economic data, to make a high-conviction case for either alternative.
That high degree of uncertainty says to me that yields on junk bonds are too low and that I’m not getting paid enough in an environment where I can’t tell how future economic growth rates and future interest rates are going to break—and when.
But that’s just me.