Investment grade bonds the route to go

SERIOUS MONEY:Time for investors to discriminate across asset classes and adjust allocations accordingly, writes CHARLIE FELL

INVESTORS HAVE enjoyed 10 weeks of virtually uninterrupted gains as risk assets of all varieties have priced out an economic and financial apocalypse. Stock market averages have jumped 35 per cent from their intra-day March low, while the yields available on both investment grade and high-yield bonds have dropped significantly from the distressed levels registered just weeks ago.

Low quality has led the advance as depressed sectors have bounced from deeply oversold levels, but the time has surely come for investors to discriminate across asset classes and adjust allocations accordingly.

Stock market valuations are still at the most attractive levels in years, but the outsized advance since March has seen the multiple on trend earnings rise to just one multiple point below the historical average. Stocks currently offer long-term real returns of 6½ to 7 per cent per annum and the probability that equities will produce superior returns versus risk-free asset over the next 10 years is still compelling at roughly 75 per cent, despite the significant rise in Treasury yields in recent weeks.

However, the premium on offer is less than two percentage points above that available on corporate bonds, which present investors with the opportunity to earn equity-like returns with bond-like risk.

Extreme risk aversion last autumn saw investors flee the corporate bond market and investment grade bonds incurred double-digit losses in a matter of weeks as they became the first victim of the forced liquidation by leveraged institutions following the collapse of Lehman.

High-yield bonds dropped 45 per cent from their peak as yields soared to more than 20 per cent.

The relative illiquidity of corporate bonds saw the yields on investment grade debt jump to more than 9 per cent or 5½ percentage points above that available on 10-year Treasuries.

These unprecedented levels were 40 per cent higher than the peak spread in 2002 and even above the historical average spread available on high-yield bonds. Forced selling simply saw the market cease to function.

Relative calm has returned to the market and high-yield bonds have delivered double-digit returns in the year-to-date, though absolute yields remain punitive. Thus, it is almost impossible for lower quality credits to conduct business as usual. The probability of default remains high while recovery rates are likely to be at record lows due to the large amounts of senior debt in the capital structure and absence of debtor-in-possession financing.

Consequently, the high-yield segment should be avoided despite the seemingly attractive yields on offer.

Investors should look to investment-grade bonds for superior risk-adjusted returns. The yield spread on offer is still almost four percentage points in spite of the respectable rally since November.

The yield spread should continue to narrow as stock market volatility returns to normal levels. It is important to note that investors in corporate bonds can be viewed as owners of default-free Treasury debt of comparable maturity who have issued an option to default to the underlying company’s shareholders. The value of this option to default moves in tandem with the underlying stock’s volatility.

An increase in price volatility raises the probability of default and thus option value causing the bond price to decline and the yield to rise. Not surprisingly, this effect combined with the flight-to-quality that accompanies extreme levels of stock market volatility, causes yield spreads to soar. But they begin to decline once price volatility returns to more normal levels.

This process has already begun but there is no reason to believe that it will not continue in the months ahead and a return to historical averages would lead to an incremental return of roughly 10 per cent relative to Treasuries.

Investors may be concerned that yield spreads may narrow due to a rise in Treasury yields as opposed to an advance in corporate bond prices. Indeed, Treasury yields have already jumped by more than one percentage point since the start of the year due to budgetary concerns, while several commentators note that yields are still at historically low levels.

However, the US Federal Reserve simply cannot allow yields to rise significantly from current levels as such a development would almost certainly derail its efforts to unfreeze the credit markets.

Furthermore, it is simply not true that yields are at historically low levels. This may be true in nominal terms but certainly not in real terms, where yields are actually at their historical average despite a fragile economic outlook.

The environment in the months ahead should favour investment grade bonds over stocks due to a renewed focus on balance sheets and cash flow.

Indeed, it is normal at this stage in the cycle for companies to curtail investment spending, shed labour, restrict dividend increases and reduce share repurchase activity.

There is already evidence of such measures been taken across the corporate sector and all are bondholder friendly. Investors should seize the opportunity and buy investment grade bonds.

charliefell@sequoia.ie