Using a variation of the Fed Model to measure equity valuation, we have charted the earnings yield (the reciprocal of the P/E ratio) for the S&P 500 versus the average yield for high-yield bonds over the past three years. While the recent underperformance of the high-yield market relative to equities points to better relative value for high-yield debt, the average spread differential over twenty years is almost three times today's level - approximately 4.3%.
Four factors contributed to the poor performance of high-yield debt during the second half of 2014:
- Fed Chair Janet Yellen's mid-year warning "in lower rated corporate debt, valuations appear stretched" as investors are reaching for yield.
- Retail-cash outflows from U.S high-yield funds expanded during the past two quarters, with investors unwinding sizeable purchases made since the financial crisis.
- Energy bonds, which represent a 15% share of the high-yield bond market, have experienced price declines as oil prices have fallen sharply.
- Concern about slowing global growth and deflationary pressures in Europe and Japan will eventually lead to increased market volatility and higher defaults.
Key Takeaway: Even though valuations in the U.S. equity markets appear reasonable when viewed over the long term in the context of today's low interest rates, widening credit spreads can often offer us an early warning signal for challenging periods of deteriorating investor sentiment and concern about future economic growth. Continued pressure on the valuation of both investment-grade and high-yield corporate debt should be closely watched as an important leading indicator for near-term equity market performance.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. All information referenced in preparation of this material has been obtained from sources believed to be reliable, but accuracy and completeness are not guaranteed. There is no representation or warranty as to the accuracy of the information and Penn Mutual Asset Management shall have no liability for decisions based upon such information.
High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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