Junk Bond Rally Signals Profits for Stocks as Markets Diverge

By Alexis Xydias

Oct. 26 (Bloomberg) -- 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.

Barclays Plc and ING Groep NV are increasing share purchases on speculation that improving corporate earnings will prolong the rally in equities and shrink the gap again. Profits for S&P 500 companies are forecast to climb 53 percent over the next two years as the Federal Reserve holds interest rates close to zero to end the worst recession since the 1930s, according to analyst estimates compiled by Bloomberg.

“For the first time in a long while, equities appear inexpensive relative to corporate bonds,” said Kevin Gardiner, the London-based head of investment strategy at Barclays Wealth, which lowered its rating on fixed-income securities to “neutral” this month and recommended owning stocks. “Valuations and the likely news flow over the coming period will inspire people to take more risk.”

Fixed Income

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.

Merrill Lynch’s High Yield Master II Index has climbed 51 percent in 2009, extending an advance from last year that pushed returns to the highest level ever relative to the S&P 500, which has increased 22 percent, including dividends. That compares with average annual gains of 9.3 percent for equities and 8.4 percent for high-yield credit since 1986, when monthly data on Merrill’s index begins.

“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?”

The cost of insuring bonds with credit default swaps fell 62 percent since March 9 to the lowest level since May 2008, according to Markit Group Ltd. New York-based S&P lowered its 12-month default-rate prediction on Oct. 21 for U.S. high-yield corporate credit to 6.9 percent, from 14.3 percent in April.

Mean Reversion

Returns evened out in the third quarter, when signs the U.S. economy was rebounding pushed the S&P 500 up 15.6 percent with dividends, compared with 14.8 percent for junk bonds. The gain was the first time the S&P 500 beat the high-yield index since the third quarter of 2008, the data show.

Investors say equities may outpace debt as the economy recovers. Gross domestic product is projected to expand 2.4 percent in 2010, according to the average estimate of economists surveyed by Bloomberg, compared with a prediction of 1.8 percent in March. Consumer confidence, U.S. retail sales and industrial production all grew more than economists forecast in reports released last month.

“Normally we had more 50-50 in stocks and bonds, and now we have two-thirds in stocks,” said Roland Schwab, a partner at Kraemer, Schwab & Co. in Zug, Switzerland, which oversees about $1.5 billion. “Stocks are definitely better valued now. In this situation, high-quality stocks are the place to be.”

Relative Value

Junk bonds beat shares by the most on record even with the S&P 500’s 62 percent return since March, according to data compiled by Bloomberg and Merrill Lynch. Before this year, the 23-year-old high-yield index had only once traded for more than half the price of the S&P 500, in 1994.

The gauge rose to 645.96 at the end of September, or 61.1 percent of the S&P 500’s price of 1,057.08. When the same ratio reached a record low of 23.9 percent in March 2000, junk bonds beat equities for three years.

McMoRan Exploration Co.’s 11.875 percent notes due in 2014 have returned 0.69 percent in October following a 54 percent rally this year through September, according to Trace, the bond- price reporting system of the Financial Industry Regulatory Authority.

Gas Rally

Shares in the New Orleans-based oil and gas producer soared 22 percent this month, compared with a 23 percent decline in the previous nine months. The rally followed a 21 percent advance in natural gas in September, the biggest gain since at least 2003, according to data compiled by Bloomberg.

The 8.75 percent notes due in 2012 of St. Louis, Missouri- based retailer Brown Shoe Co. jumped 33 percent between January and the end of September, excluding reinvested interest, according to Merrill Lynch & Co. data, while its stock retreated 5.3 percent. Shares in the company, which beat analysts’ profit estimates for three quarters, have rallied 46 percent since Sept. 30, compared with a 0.8 percent advance in the bonds, the data show.

“From a pricing standpoint, junk bonds have absolutely run their course,” said Jason Brady, a managing director at Thornburg Investment Management in Santa Fe, New Mexico, which oversees $50 billion. Brady manages both stocks and bonds in the $3.8 billion Thornburg Income Builder Fund, which has beaten 98 percent of its competitors in the past five years.

Still Cheap

Peter Acciavatti, who runs the top-rated junk-bond research team at New York-based JPMorgan Chase & Co., said on Oct. 16 that high-yield debt is still cheap. Slowing job losses and an improving housing market will narrow yields relative to benchmark rates, he said. His team has been ranked first among its peers in Institutional Investor’s annual poll for the past seven years.

The Federal Reserve said Sept. 23 that it will slow its $1.45 trillion program of buying mortgage securities as an economic recovery takes hold. Chairman Ben S. Bernanke indicated for the first time since August 2008 that the economy is accelerating.

Executives are shifting their focus to expansion after preserving cash for most of the year, a strategy that will profit shareholders more than bond investors, according to Edmund Ng, a strategist at Morgan Stanley in London. U.S. companies are emerging from the worst recession in seven decades with a record $1.5 trillion in cash after slashing more than 7 million jobs since December 2007.

Beating Estimates

More than 80 percent of S&P 500 companies that have reported third-quarter results have beaten analyst earnings estimates, exceeding the record pace of 72.3 percent for the period ended in June. Gross domestic product grew in the U.S. at a 3.2 percent annual rate last quarter after shrinking during the previous year, according to the median estimate of economists surveyed by Bloomberg.

“While nine months ago it was time to prefer credit over equities, we think now it is time to flip the trade around,” said Ng. “The rapid repricing of credit in 2009, and a shifting economic and earnings backdrop, suggest that a strong asset allocation argument for credit which existed at the start of the year has now largely vanished, or even reversed.”

The S&P 500 has returned 2.2 percent in October including dividend payments, beating the 1.9 percent gain in Merrill Lynch’s high-yield index. The Dow Jones Industrial Average rose above 10,000 for the first time in a year after profits from JPMorgan Chase and Intel Corp. in Santa Clara, California, topped analyst estimates and the price of oil added 14 percent.

Rising Profits

Profits in the S&P 500 will increase 67 percent this quarter, according to analysts polled by Bloomberg. S&P 500 earnings will increase 25 percent in 2010 and 22 percent in 2011, the analyst data shows.

ING Investment Management, which oversees $507 billion, has equal amounts in stocks and fixed income, with a preference for investment-grade debt over high-yield bonds. Equities may outperform as dividends rise with earnings and mergers and acquisitions gain pace, according to Patrick Moonen, the firm’s senior equity strategist in The Hague.

“Performance year-to-date started in the credit space and equities followed,” said Moonen. “But relative to credit, equities still have room to improve. Equities may be the better investment proposal.”

To contact the reporters on this story: Alexis Xydias in London at axydias@bloomberg.net.