Equity and High Yield Bond Valuations Through the ‘Fed Model’ Lens: A Look Back and Ahead

January 24, 2019

Equity and High Yield Bond Valuations Through the ‘Fed Model’ Lens: A Look Back and Ahead Photo

This week’s chart takes our second look at valuations for 10-year Treasuries, the S&P 500 Index and high yield bonds using the “Fed Model,” which compares the 10-year Treasury yield with the S&P 500 earnings yield (reciprocal of the P/E ratio). We added high yield bonds to the mix in order to gauge relative value between equity and credit risk. I argued in early 2015 that through this lens, widening credit spreads (often a leading indicator of higher equity market volatility) signaled more challenging times ahead for equity markets. Equity and high yield credit performance did struggle until early 2016, when oil prices ultimately bottomed. 

The swift and dramatic widening in risk premiums last quarter was again accompanied by a steep decline in oil prices. Lower energy prices stirred fears of higher defaults among increasingly vulnerable corporate borrowers (especially at the growing BBB-rating level), and could potentially push an already wobbly global economy into another downturn.


Key Takeaway

Despite the sell-off in equity and credit markets last quarter, risk premiums today for both equity and high yield credit stand remarkably close to early 2015 levels. While the ending point is nearly identical, the path to get here has not been. High yield credit spreads have been nearly twice as volatile as equity risk premiums since early 2015. Increasing leverage on corporate balance sheets, challenging corporate bond liquidity conditions and greater sensitivity to oil prices, all factor into this changing relationship. The bottom line for investors from our 2015 Chart of the Week is still the case today – watch investment-grade and high yield corporate credit markets as leading indicators for near-term equity market performance.



Tags: High yield | Credit spreads | Investment grade corporate bonds | high yield bonds | 10-year Treasuries

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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.

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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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