Junk bonds have outperformed equities by a wide margin since their inception in the late 1980s. However, our Global Asset Allocation service anticipates a change for the following reasons:
- Highly attractive relative valuations: The spread between the yield on equities and junk bonds is near record levels. In fact, the ‘search for yield’ has pushed the spread into positive territory, an extremely rare occurrence prior to the Great Recession. Though valuations tend to be poor indicators of short-term performance, extreme levels such as these, limit downside risk and lend support to a longer term change in relative performance.
- Corporate Activity: Companies have every incentive to continue financing stock buybacks with debt. Corporate balance sheets are strong and financing costs after taxes and inflation are negligible. This directly undermines high yield returns compared to equities.
- A supportive growth backdrop: The relationship between relative equity/high yield performance and real global growth is straightforward. Positive growth is highly correlated with equity outperformance. Conversely, high yield tends to outperform stocks in recessionary environments. Our base case is that growth continues to edge upwards in 2014. But even if growth does slow, none of our recession indicators are flashing red, and it is very difficult to envision a scenario where growth is negative.
- Interest rate normalization should be relatively equity friendly, assuming no ‘policy mistake’.
Bottom line: After several years of relative underperformance, the risk/reward profile is leaning in favor of stocks vs. high yield.