What Junk Bonds Tell Us About Stocks

Individual investors prefer to read about stocks -- bonds are just plain boring. But there's plenty to learn from watching the bond markets right now, particularly those for high-yield ("junk") bonds, which are closer to equity than their investment-grade brethren. The lessons from this market could prevent stock investors from suffering unnecessary losses.

Record amounts of junk
It strains belief, but the global issuance of high-yield bonds reached a record $67.8 billion in the first quarter. Even jitters concerning the risk of sovereign credits -- which are normally considered "risk-free" (more on this later) -- could not derail the junk train. March became one of the most active months ever for this market. Even without the Greek crisis, those milestones look extraordinarily inconsistent with a fragile global economy that is barely emerging from the greatest crisis in our lifetime, and still at the mercy of unprecedented economic/ policy risks.

A technical aberration?
High-yield bonds aren't the only segment of the bond market displaying red flags, either. Last week, the 10-year swap spread, which measures the incremental cost corporate bonds pay on borrowed funds above the 10-year Treasury yield, turned negative for the first time ever. In other words, some private borrowers are able to fund themselves at better rates than the U.S. government. (On Tuesday, the seven-year swap spread also crossed into negative territory.)

This phenomenon is at least partly attributable to supply and demand, but there is no question that market participants are revisiting their notions concerning the "risk-free" label. This is a healthy re-evaluation. Nonetheless, if Greece defaults on its debt, for example, I expect junk bond spreads to widen substantially, handing the investors who own the bonds substantial paper losses.

There is a link with stocks
What does this have to do with stocks, you ask? Take a look at the following table, which contains seven stocks that rank among the S&P 500's top performers for March. Make no mistake about it: These stocks are the equity equivalent of junk bonds; the companies are in the highest quintile in terms of leverage or bankruptcy risk (as measured by the Altman Z-Score) -- or both. That doesn't appear to bother the people bidding their shares up:

Company

March Return*

Total Debt/ Equity

American International Group (NYSE: AIG  )

38%

208%

Starwood Hotels & Resorts (NYSE: HOT  )

22%

162%

Wynn Resorts (Nasdaq: WYNN  )

22%

118%

Citigroup (NYSE: C  )

20%

--

Marriott (NYSE: MAR  )

17%

201%

Advanced Micro Devices (NYSE: AMD  )

17%

730%

Ford Motor (NYSE: F  )

13%

NM

*Through March 30, 2010.
Source: Capital IQ, a division of Standard & Poor's.

Beyond financial leverage
You can extend the stock-junk bond analogy beyond mere leverage. Cyclical stocks are similar to junk bonds in their greater sensitivity to changes in economic activity. Do cyclical stock valuations reflect macroeconomic risks, or are they overbought? David Rosenberg, chief strategist at Canadian asset manager Gluskin Sheff, argues for the latter. After performing statistical analysis on the valuations of cyclical sectors of the S&P 500, Rosenberg concludes that "they have priced in an extremely robust economic landscape" – a landscape that isn't on the horizon. Here are two examples:

  • S&P 500 retail stocks are pricing in 7.5% year-on-year growth in retail sales, against current growth of 3.9%.
  • S&P 500 homebuilders are "arguably … the most expensive part of the market," according to Rosenberg. The sector pricing in housing starts ranges from 800,000 to 900,000, against a current level of 575,000.

Vigilance is the watchword
Although the powerful stock rally off the market's March 2009 low may have lulled stock investors into believing that all is well while Father Bernanke's on watch, investors should be their own sentries. Ultra-low official interest rates prod many investors to "reach for yield" in all the wrong places, but I recommend underweighting cyclical and leveraged companies and overweighting high-quality companies. It's also advisable to have exposure outside the developed markets, which are beginning to look increasingly bailout-weary.

Between high valuations and slow growth, investors should expect disappointing returns from U.S. stocks over the next several years. Tim Hanson explains how to make more in 2010

Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. Ford is a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


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