(Bloomberg News) Junk bonds are poised to extend their lead over U.S. equities into a fifth year as debt investors bet that the American economy will keep expanding even if profit growth slows.
Speculative-grade debt has beaten the Standard & Poor's 500 Index by 53 percentage points since October 2007, as the bonds returned 34 percent and the benchmark measure for U.S. equity fell 19 percent, according to data compiled by Barclays Plc and Bloomberg. Investors who held junk-rated bonds of Ford Motor Co. earned seven times as much as shareholders, while debt from Sprint Nextel Corp. and J.C. Penney Co. beat their stocks.
The widening gap shows equity investors are growing more concerned that the sluggish economy will hurt profits even though the debt market doesn't anticipate a jump in defaults or a new recession. Bears say it's only a matter of time before earnings decline as manufacturing slows from China to Germany, Europe's debt crisis worsens and the U.S. jobless rate remains stuck near 9 percent.
"Earnings are already at fairly high levels and to sustain continued earnings growth from here we still need to see reasonably good economic growth," Jeremy Zirin, who helps oversee $715 billion as New York-based chief U.S. equity strategist at UBS Wealth Management Americas, said in a telephone interview on Nov. 23. "The bond market doesn't believe we will have a meaningful increase in default rates."
Default Rate
The trailing 12-month speculative-grade default rate will rise to 3.1 percent by September 2012, below the long-term average of 4.59 percent, New York-based S&P said this month. The rate was 1.94 percent at the end of September.
Analysts' estimates show earnings at S&P 500 companies will climb 10 percent to $109.04 a share in 2012, according to data compiled by Bloomberg. The profit projection for next year has been cut by 4.2 percent since Aug. 4. Estimates imply 17 percent growth for 2011, down from 20 percent in June. The S&P 500 rose 2.9 percent to 1,192.55 today.
Stocks in the S&P 500 trade at 12.2 times reported earnings. Before the financial crisis in 2008, the valuation hadn't been that low since 1989, data compiled by Bloomberg show. Yields on speculative-grade bonds, rated below Baa3 by Moody's Investors Service and BBB- by S&P, average 6.73 percent, compared with 1.96 percent on benchmark 10-year Treasuries. Their spread reached 5.10 percentage points in September, the widest since 2003, the data show.
'Supportive Valuations'
"Investors are looking at both asset classes and seeing supportive valuations," Chris Sheldon, New York-based chief investment officer at Dreyfus Corp., which oversees about $450 billion, said in a telephone interview on Nov. 23. "But investors are judging the risk in high-yield to be more fine lined or more understandable," he said. "The equity risk premium is quite high."