High Yield vs. Investment-Grade
Investment-grade corporate bonds, nonetheless, have significant exposure to interest rate risk, especially as their durations have lengthened significantly due to the low base rate. For investors with no natural demand for duration exposure, high yield corporate bonds may represent a convenient way to improve yields significantly without taking on undesired interest rate risk.
The historical high yield spread averages around 5.9%, but the current yield spread is 6.4%. This betokens a not insignificant opportunity for further yield compression, especially in view of the market’s current appetite for yield. Adjusting for default losses, investors can still expect a premium of about 4–4.5% over the comparable maturity Treasury portfolio. High yield bonds are admittedly running substantially below their historical level of 11%, but for investors today the more relevant factor is the above average yield spread to treasuries. Again, Table 2 summarizes the current yield characteristics of high yield bonds versus their historical values.
More interestingly, a high yield bond portfolio tends to deliver higher returns in reflationary environments. This property makes it unique among corporate bonds and more akin to inflation indexed instruments. Statistically, high yield bond portfolios exhibit about a 25% correlation with inflation, whereas the BarCap Agg Bond Index exhibits a –35% correlation. Remarkably, REITs and TIPS only exhibit a correlation with inflation of approximately 20%. At a time when inflation-fighting assets are priced extremely rich (observe TIPS at negative yields and gold at $1,700 an ounce), this defensive characteristic of high yield bonds may attract significant flows from inflation-sensitive investors.
Part II. Equities
In the second part of the analysis, I examine the relevant macro drivers for U.S., other DM, and EM equities.
EPS Growth Risk
Growth in earnings per shares is one of the most significant engines for long-term equity returns. In the United States, EPS growth has surpassed the historical trend rate in the post-crisis period (see Figure 3). Note that the EPS growth is cyclical; that is, the growth rate tends to be above trend during the expansionary phase of a business cycle and below trend in the contraction phase. While the cyclicality is intuitive, it is, however, often ignored. Both research analysts and investors alike are prone to over-extrapolate the recent growth rate into the future and pay high prices (high P/E) after a period of strong EPS growth. This can then create a counter-cyclical pattern to equity returns, where the above trend growth rate experienced during the expansionary phase lead to rich valuation levels, which then produce low future returns.