This Red-Hot Market Is a Red Flag

Before you dismiss this article because it's based on observations about the bond market, let me assure you I will provide actionable advice here for stock investors. The red-hot market I'm referring to in the headline is the high-yield (or "junk") bond market -- bonds rated below investment grade by the credit ratings agencies. From the market's bottom on Dec. 12, 2008, U.S. junk bonds have produced a total return of 88%, using the Merrill Lynch High-Yield Master II index. That beats even the extraordinary rally in U.S. stocks from their March 9, 2009, low (+75%). In both cases, the magnitude of the gains should be a red flag to all prudent investors.

Investors' ravenous appetite for junk
The rally is a product of investors' ravenous appetite for high-yield bond issues, and another sign that the Fed's zero-interest-rate policy is distorting the market's risk-pricing function. In March, global issuance of junk bonds reached a record $36.7 billion and the tally for April was the second-highest on record ($32.2 billion). In other words, investors are lending record amounts of money to the riskiest group of companies less than three years after the start of the greatest credit crisis in history, a crisis which will have knock-on effects for years to come, some of which may not yet be clearly understood.

The desperation to eke out a return better than that on funds stuffed into a money market mattress can push investors to forget the very basis of sound investing. As Gluskin Sheff strategist David Rosenberg took the trouble to remind us recently, "the operative strategy ... is to be paid to take on risk as opposed to paying for taking on risk."

Investors aren't getting paid
One thing should be quite clear: U.S. high-yield investors aren't getting paid right now, receiving just 4.5 percentage points in extra yield above the rate on 10-year U.S. Treasury bonds. That is three-quarters of a percentage point below the historical average, which is clearly inadequate compensation in an environment characterized by risks that many professional investors have never witnessed in their lifetimes, let alone during their investing careers.

The ultimate outcome is predictable. Speaking yesterday at a Hong Kong conference on distressed investing, New York University finance professor Edward Altman said of the high-yield market: "I'm concerned it has come back too fast and too furious. There will be a correction." Altman developed the Altman Z-Score, a measure of bankruptcy risk based on accounting and market data.

Avoid high-yield bond ETFs and low-quality common shares
Now is clearly not the time for investors to purchase the SPDR Barclays Capital High Yield Bond ETF (NYSE: JNK) or the iShares iBoxx High Yield Corporate bond ETF, but those aren't the only securities they should avoid. Back in August 2009, I highlighted the "junk rally" in stocks, in which the shares of the lowest-quality companies were outperforming those of higher-quality names.

For examples of this phenomenon, here are the six stocks that are in the top decile of S&P 500 nonfinancials, both in terms of price return off the market's March 9, 2009, low and bankruptcy risk (as measured by Altman's Z-score):

Source: Capital IQ, a division of Standard & Poor's.
*Through May 3, 2010.
**Based on estimates of next fiscal year's earnings per share.

Thanks to massive price gains, this group is hardly trading at distressed levels. If we throw out Micron, the next-lowest forward price multiple in the group is that of CBS Corp., at 14.1 on the basis of next fiscal year's estimated earnings per share -- in line with the valuation of the (overpriced) broad market.

Overvaluation + cyclicality = risk of permanent capital loss
With the exception of Tenet Healthcare, all are cyclical and therefore vulnerable to any hitch in the economic recovery. That's a genuine risk, given the tricky handoff that needs to occur between the government's all-too-visible hand and legitimate economic demand. Expensive and vulnerable to economic shocks is a highly undesirable combination for a stock.

Looking ahead, I expect the Eurozone sovereign debt crisis to usher in a new focus on credit quality, which will result in higher yields/lower prices on junk bonds. Equity investors in the same companies -- who are lower down in the capital structure -- should expect the same result.

High-quality stocks will outperform
This process could already be under way: Last month, the VIX, investors' "fear gauge," dropped to a 33-month low. Since then, it has risen by 53%, including an 18% increase yesterday alone. As investors reacquaint themselves with risks they tried mightily to ignore, I suspect we may finally be entering a period in which the market has exhausted its capacity to reward marginal companies. For stocks, the "high-quality" theme is more timely than ever.

The credit crisis has turned the investing landscape upside-down, with advanced economies' balance sheets now looking less than sturdy. In that context, Fool Tim Hanson explains how to make more in 2010.