JULY 31, 2010
By MARK GONGLOFF
Bonds continue to trounce stocks, sending mixed signals to investors and raising the question: Are stocks too cheap or are bonds too expensive?
After consistently lagging behind bond performance this year, stocks appear historically cheap compared with bonds, offering investors reason to favor stocks, particularly if they are optimistic about the economic outlook. But stocks may be cheap because the outlook is dim, meaning bonds—from Treasurys to corporate debt—could continue to outperform for the foreseeable future.
So far this year, the stock market's total return is slightly negative, while normally staid investment-grade corporate bond returns are up nearly 8%, according to Bank of America Merrill Lynch indexes. Even risk-free Treasury returns are up 6%.
Stocks made up some ground with a 7.1% rally in the Dow Jones Industrial Average in July. But such stock rallies have stalled repeatedly in recent months as weak economic data have outweighed signs of hope from corporate earnings. The yield on the 10-year Treasury note has dropped below 3% as investors scramble for safe havens, and the demand for corporate bonds is booming.
One way to compare the relative value of stocks and bonds is to compare their yields, or the amount of cash each asset generates on a regular basis.
Bond yields are easy to see; stock yields are trickier. Many analysts like to use something called an "earnings yield," which is the inverse of a company's price/earnings ratio. While imperfect, earnings yield measures how much cash a company generates for itself and its shareholders as a percentage of its price. As with bonds, higher yields represent lower prices, and vice-versa.
At the end of trading Friday, the earnings yield on the Standard & Poor's 500 index was 6.6%, based on the past four quarters' operating earnings, the highest since 1995.
The gap between that yield and the 10-year Treasury yield—a measure of the cheapness of stocks relative to Treasury bonds—is the widest about 30 years, according to Jason DeSena Trennert, chief investment strategist at Strategas Research Partners.
To Mr. Trennert, this suggests that stocks are too cheap, bonds are too expensive after a strong rally this year, or both.
"People are so risk-averse now that a tremendous potential opportunity is being created in stocks," he said.
He warned, however, that it could take time for that opportunity to be realized, given the high levels of uncertainty about the economic outlook. "The reasons we're seeing this are secular in nature," he said. "They reflect very long-term problems that are not easily fixed."
It isn't exactly surprising for bonds to outperform stocks during a period when stocks are falling. Except for periods of high inflation, corporate bonds, particularly investment-grade, often hold up better in an environment where stocks are falling.
But even last year, when stocks enjoyed one of their most stirring rallies in history, there were at least two long episodes during the bull run when corporate bonds outperformed, according to an analysis by Jason Quinn, co-head of high-grade and high-yield flow trading at Barclays Capital, comparing stock prices to bond yields. In contrast, in the bull market that followed the 2001 recession, stocks outperformed bonds consistently.
In the eyes of stock-market bulls, the underperformance this time around has left corporate bonds expensive and stocks attractively cheap, pricing in dire economic outcomes that most forecasters still don't think likely.
"You would have to believe in at least a mild recession to prefer corporate bonds over equities at this stage," said David Bianco, chief U.S. equity strategist for Bank of America Merrill Lynch.
Mr. Bianco prefers to compare the stock market's earnings yield to the yield on 10-year Treasury Inflation-Protected Securities, as TIPS yields include inflation protection while stock prices and dividend yields do not.
Today, that gap is about six percentage points, compared with about three historically, according to Mr. Bianco—suggesting stocks are underpriced relative to bonds, particularly given how low inflation is.
"I would argue that the asset class with the most upside, even in a scenario of slow growth, is equities," said Mr. Bianco, who has a 12-month target of 1350 for the S&P 500.
The recent outperformance of bonds is also partly a reflection of the fact that individual investors have largely turned their back on stocks after two crushing bear markets and a decade of negative returns.
Despite last year's stock-market rally, one of the best on record, individual investors pulled money from stock mutual funds and poured them into bond funds. The trend has continued this year, with long-term stock funds suffering a net $1.1 billion in outflows and bond funds enjoying $177.6 billion in inflows, according to the Investment Company Institute.
"Investors over the decade of the 2000s were protected by the bond market and beaten up by the stock market," said David Kelly, chief market strategist for J.P. Morgan Funds. "That memory is so powerful in their minds that they'd rather overpay for a bond than underpay for a stock."
Skeptics note that bonds have outperformed stocks partly because economic growth has been too sluggish to help stocks go very far, but not so slow that it pushes companies, many of which are loaded with cash, into default. If such conditions persist as many observers believe, then the stock market could continue to lag behind.
"We could end up with slower growth than people think, and that's not going to be great for the equity market, but it doesn't really matter for credit," said Mr. Quinn of Barclays Capital.
Many skeptics warn that a key difference between this recovery and others where stocks consistently outpaced bonds is the withering of private borrowing and the financial sector, big drivers of recovery in economic and corporate-profit growth in prior expansions.
Private-sector borrowing has shrunk in this recession for the first time since the Great Depression, notes Northern Trust chief economist Paul Kasriel, who in July cut his forecast for annualized economic growth in the second half of 2009 to 1.8% from 2.5%.
He noted that private borrowing continues to contract despite near-zero interest rates from the Federal Reserve. Stimulus is set to fade and unemployment remains high. Under such conditions, borrowing will remain low, and the scarcity of new debt will prop up its value.
"The risk premium in the bond market will increase, but I'm not going to put that bet on now," Northern Trust chief investment officer Bob Browne said in an interview.
from the wall street journal published on JULY 31, 2010
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ANALYSIS - Banks rethink may prompt investor return from junk
Fri Jul 30, 2010 2:16pm IST
By Natsuko Waki
LONDON (Reuters) - Investors wary of investment grade corporate bonds because of a heavy presence of banks in them may have a rethink thanks to greater clarity surrounding European banks, prompting a switch back from high-yield debt.
High-yield bonds -- typically riskier paper rated below investment grade -- have been a hot credit asset over the past year as it was an "ex-banks" trade for those who were worried about the fallout from Europe's sovereign debt crisis.
This resulted in a rush of funds into the so-called junk space, with fund tracker EPFR estimating nearly $6 billion had flown into a broader high-yield bond universe since January.
However, the tide may be turning in favour of higher-quality investment grade after last week's European bank stress tests were conducted without incident and banking regulators scaled back proposals to beef up global bank capital and liquidity rules.
"High yield has outperformed basically because it was not banks. That was pretty much the best thing you could say about the asset class," said Christian Dinesen, head of international corporate credit research at Bank of America Merrill Lynch.
"But for the rest of the year, senior financials should, particularly after this benign result of the stress test, have a pretty good run. High-yield is okay but ... risk-return wise investment grade is probably better."
A Reuters poll of global asset managers published on Thursday showed exposure to investment grade bonds rose to 22.6 percent in July from 19.7 percent in June. High yield debt was less popular.
Until now, investment grade bonds have struggled this year, especially in Europe, where more than one in two issues come from banks.
European high-grade corporate issues, which have sovereign-like ratings in the investment grade space, returned 0.7 percent less than benchmark governments this year, BofA Merrill estimated.
In contrast, junk debt gave an excess return over government bonds of 0.94 percent in the same period.
Based on prices, global junk debt rose 22.7 percent over the past year while top-rated corporates gained 7.3 percent.
BofA Merrill forecasts spreads of high grade European debt to tighten 27 basis points from current levels to 202 bps towards the year end, giving an excess return over government bonds of 1.5 percent.
Goldman Sachs expects spreads of triple-B issues -- the riskiest segment within the investment grade space -- to hit 175 bps this year, their lowest since late 2007.
The positive performance outlook comes against a backdrop of falling default rates. According to Standard & Poor's, the 12-month rolling default rate for global investment grade paper stands at just 0.21 percent, down from 0.41 percent in 2008.
"We remain confident in investment grade, this is one of our clear risk trades. The risk rewards are clearly tilted towards the positive side. On HY, valuation is a little bit too stressed," said Franz Wenzel, senior strategist at AXA Investment Partners in Paris.
A Fitch survey of 85 asset management houses showed investment grade financials moved to the top slot for most favoured credit investment choice, with 21 percent of investors picking them, versus 14 percent for emerging market firms.
HIGH YIELD RISKS
High-yield debt by definition gives a higher return than investment grade bonds, but it carries a bigger risk of default and loss on principal and interest.
Furthermore, supply risk appears to be higher in the junk universe. Citi expects high yield to be the only key market where issuance is likely to be higher than 2009 and to be one of the highest in the past 10 years, at over $200 billion.
Investment grade bonds can also be appealing when compared with equities, especially for those who are looking to increase exposure in the banking sector. Apart from its intrinsic structure that is safer than equity, valuation is one reason.
Generally speaking, investment grade credit has lagged equities in recovering from a May sell-off.
The credit derivatives swap index for most-liquid investment grade issues in Europe, measured by the iTraxx , fell 26.4 percent since its May risk aversion peak. The VIX that measures equity option volatility more than halved.
"When you're investing in credit, all you care about is to get your money paid back," Dinesen said.
"When it comes to comparing banks in terms of equity and credit, in a scenario like this, you're likely to get the performance first in credit, then in equities."
(Additional reporting by Jeremy Gaunt, editing by Mike Peacock)
(For more business news on Reuters India click in.reuters.com)
From Reuters published on Fri Jul 30, 2010 2:16pm IST
By Natsuko Waki
LONDON (Reuters) - Investors wary of investment grade corporate bonds because of a heavy presence of banks in them may have a rethink thanks to greater clarity surrounding European banks, prompting a switch back from high-yield debt.
High-yield bonds -- typically riskier paper rated below investment grade -- have been a hot credit asset over the past year as it was an "ex-banks" trade for those who were worried about the fallout from Europe's sovereign debt crisis.
This resulted in a rush of funds into the so-called junk space, with fund tracker EPFR estimating nearly $6 billion had flown into a broader high-yield bond universe since January.
However, the tide may be turning in favour of higher-quality investment grade after last week's European bank stress tests were conducted without incident and banking regulators scaled back proposals to beef up global bank capital and liquidity rules.
"High yield has outperformed basically because it was not banks. That was pretty much the best thing you could say about the asset class," said Christian Dinesen, head of international corporate credit research at Bank of America Merrill Lynch.
"But for the rest of the year, senior financials should, particularly after this benign result of the stress test, have a pretty good run. High-yield is okay but ... risk-return wise investment grade is probably better."
A Reuters poll of global asset managers published on Thursday showed exposure to investment grade bonds rose to 22.6 percent in July from 19.7 percent in June. High yield debt was less popular.
Until now, investment grade bonds have struggled this year, especially in Europe, where more than one in two issues come from banks.
European high-grade corporate issues, which have sovereign-like ratings in the investment grade space, returned 0.7 percent less than benchmark governments this year, BofA Merrill estimated.
In contrast, junk debt gave an excess return over government bonds of 0.94 percent in the same period.
Based on prices, global junk debt rose 22.7 percent over the past year while top-rated corporates gained 7.3 percent.
BofA Merrill forecasts spreads of high grade European debt to tighten 27 basis points from current levels to 202 bps towards the year end, giving an excess return over government bonds of 1.5 percent.
Goldman Sachs expects spreads of triple-B issues -- the riskiest segment within the investment grade space -- to hit 175 bps this year, their lowest since late 2007.
The positive performance outlook comes against a backdrop of falling default rates. According to Standard & Poor's, the 12-month rolling default rate for global investment grade paper stands at just 0.21 percent, down from 0.41 percent in 2008.
"We remain confident in investment grade, this is one of our clear risk trades. The risk rewards are clearly tilted towards the positive side. On HY, valuation is a little bit too stressed," said Franz Wenzel, senior strategist at AXA Investment Partners in Paris.
A Fitch survey of 85 asset management houses showed investment grade financials moved to the top slot for most favoured credit investment choice, with 21 percent of investors picking them, versus 14 percent for emerging market firms.
HIGH YIELD RISKS
High-yield debt by definition gives a higher return than investment grade bonds, but it carries a bigger risk of default and loss on principal and interest.
Furthermore, supply risk appears to be higher in the junk universe. Citi expects high yield to be the only key market where issuance is likely to be higher than 2009 and to be one of the highest in the past 10 years, at over $200 billion.
Investment grade bonds can also be appealing when compared with equities, especially for those who are looking to increase exposure in the banking sector. Apart from its intrinsic structure that is safer than equity, valuation is one reason.
Generally speaking, investment grade credit has lagged equities in recovering from a May sell-off.
The credit derivatives swap index for most-liquid investment grade issues in Europe, measured by the iTraxx , fell 26.4 percent since its May risk aversion peak. The VIX that measures equity option volatility more than halved.
"When you're investing in credit, all you care about is to get your money paid back," Dinesen said.
"When it comes to comparing banks in terms of equity and credit, in a scenario like this, you're likely to get the performance first in credit, then in equities."
(Additional reporting by Jeremy Gaunt, editing by Mike Peacock)
(For more business news on Reuters India click in.reuters.com)
From Reuters published on Fri Jul 30, 2010 2:16pm IST
Bill Gross: Bonds Have Seen Their Best Days And Stocks Are The Better Investment
Vincent Fernando, CFA
As Pimco begins to offer stock investment funds, after establishing itself as the largest bond fund manager in the world, Bill Gross sheds light on the firm's strategic thinking.
Bonds have done well over the last thirty years, and this has earned Pimco a lot of money since many investors now favor bond investments over stocks.
Yet, the next ten years could be much different, and Pimco doesn't want to be stuck in last decade's asset class.
Washington Post:
The three-decade rally in bonds, the securities that made Gross famous, will eventually fizzle out, according to Pimco's outlook. Gross said the rally will come to an end as nations sell record amounts of debt to fund their deficits, spurring a return of inflation and rising interest rates.
"Bonds have seen their best days," said Gross, who anticipates returns of 4 to 5 percent in the new normal.
The king of bonds is now talking up stocks as a better long-term investment. He said that as U.S. Treasury returns fall, investors will have to take more risk with high-yield bonds, equities and, eventually, real estate.
"If you're talking about the next 10, 15, 20 years, there's certainly the recognition that assets will grow faster in those categories," he said. "Over the long term, stocks return more than bonds when appropriately priced at the beginning of an investment period."
It's easy to be a bit cynical here and say Mr. Gross is talking up his company's latest product offering, as we've been guilty of in the past. Nevertheless, one has to admit that despite Pimco's new move into offering stock funds, it would still benefit the firm more, from a purely marketing perspective, to continue pushing bonds over stocks given that the majority of Pimco's business remains in bond investment. Thus a cynic's view of Mr. Gross's latest stocks vs. bonds assessment doesn't hold water.
From The Business Insider published on Mon Jul. 26, 2010, 5:19 AM
As Pimco begins to offer stock investment funds, after establishing itself as the largest bond fund manager in the world, Bill Gross sheds light on the firm's strategic thinking.
Bonds have done well over the last thirty years, and this has earned Pimco a lot of money since many investors now favor bond investments over stocks.
Yet, the next ten years could be much different, and Pimco doesn't want to be stuck in last decade's asset class.
Washington Post:
The three-decade rally in bonds, the securities that made Gross famous, will eventually fizzle out, according to Pimco's outlook. Gross said the rally will come to an end as nations sell record amounts of debt to fund their deficits, spurring a return of inflation and rising interest rates.
"Bonds have seen their best days," said Gross, who anticipates returns of 4 to 5 percent in the new normal.
The king of bonds is now talking up stocks as a better long-term investment. He said that as U.S. Treasury returns fall, investors will have to take more risk with high-yield bonds, equities and, eventually, real estate.
"If you're talking about the next 10, 15, 20 years, there's certainly the recognition that assets will grow faster in those categories," he said. "Over the long term, stocks return more than bonds when appropriately priced at the beginning of an investment period."
It's easy to be a bit cynical here and say Mr. Gross is talking up his company's latest product offering, as we've been guilty of in the past. Nevertheless, one has to admit that despite Pimco's new move into offering stock funds, it would still benefit the firm more, from a purely marketing perspective, to continue pushing bonds over stocks given that the majority of Pimco's business remains in bond investment. Thus a cynic's view of Mr. Gross's latest stocks vs. bonds assessment doesn't hold water.
From The Business Insider published on Mon Jul. 26, 2010, 5:19 AM
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