The US Federal Reserve made its first purchase of high yield bonds on 12 May and the asset class has outperformed equities since. The relative valuation between the two assets has converged as a result, but high yield bonds still have scope to outperform equities should investor risk appetite remain healthy.
This week’s Chart Room shows the difference between the average yield on US high yield bonds and the 1-year forward earnings yield for the S&P 500 - a popular metric for comparing the relative attractiveness of the two asset classes. The forward price-to-earnings (PE) ratio for the S&P 500 ended last week back at its pre-crisis level of 23.4 times last year’s earnings. The same metric based on 1 year forward earnings now exceeds its pre-crisis level. This shows a staggering recovery after the 30 per cent sell-off in the index price level between February and March.
The rally in high yield bonds has been no less impressive. Their average yield is back to just below 7.0 per cent after peaking at 11.2 per cent in late March, but this is still above pre-crisis levels. The difference between this average bond yield and the equity earnings yield has narrowed to 2.3 per cent from its peak - but this gap remains some way off its average in recent years of 0.4 per cent.
The main reason this spread did not blow out to the same extent as 2008/09, when it reached the low teens, was the Fed’s swift and significant response. This also limited the equity market sell off compared with the negative 50 per cent we saw in 2009.
Based on this, the case for high yield bonds looks compelling but there are some important considerations. Firstly, sector composition can explain some of the difference. US high yield has much larger exposure to energy companies, which warrant a higher risk premium, and lower exposure to tech. Secondly, the average high yield company has a much smaller market capitalisation than the average S&P 500 company, which also warrants a higher risk premium.
Nevertheless, investors may begin to take greater comfort by owning high yield bonds that benefit from a more visible income stream and buyer of last resort. The Fed’s latest move to buy individual corporate bonds is a positive catalyst, and a sign of further support on the way.