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Bonds Versus Stocks In Three Charts

Tyler Durden's picture





 

We have previously eschewed the constant refrain of any and every talking head who pounds the table on adding to equity risk on the basis of 'low' interest rates - why wouldn't you earn the higher dividend? or how much lower can rates go? However, aside from the drawdown-risk and empirical failure of the stocks-bonds arguments, there are three very pressing reasons currently for reconsidering the status quo of bonds against equities. Volatility in equity markets has been considerably higher than bonds and even at elevated earnings yields, it is no surprise that risk-savvy investors prefer a 'safer' lower-vol yield. Furthermore, when compared to a long-run modeling of business cycle shifts in stocks and high yield credit markets, stocks remain notably expensive to the credit cycle. Simply put, corporate bonds are at best offering better value than stocks if your macro position is bullish (and are forced to put money to work) and at worst suggest being beta-hedged is the best idea (or market-neutral) or in Treasuries.

 

Morgan Stanley's European credit research group are relatively bullish. While there are a number of reasons, including high saving rates with its accompanying demand for bonds, the chart below indicates bonds (more specifically European, Asian, and US high yield bonds) offer considerably better value than stocks currently when compared to recent volatility.

 

They note:

We believe that credit still looks attractive in the global asset allocation landscape, as it has less of a valuation problem than high-quality government bonds do and less of a volatility problem than stocks do today.

 

Thanks to the negative correlation of spreads and rates, corporate bonds have actually experienced lesser volatility than risk-free sovereign bonds. In fact, even HY credit has been less volatile than high-quality sovereigns.

 

Not only is the yield and volatility of the asset important from an asset allocation perspective, but also the correlation in a portfolio context. The superior yield over sovereigns but the negative correlation between credit and risk-free rates and the low volatility of corporate bonds is a major attraction of credit from a portfolio point of view.

 

But, the case for bonds over stocks is strengthened when we consider how each is priced on a recessionary basis. MS is starting from a bullish perspective and putting money to work in the best value asset - which makes sense if you have that macro view - and note that while BBB spreads are notably wider than recession averages, equity multiples are not excessively low by historical standards:

 

Furthermore, as Capital Context notes recently, the current environment when considered across the cycle suggests that there remains a downside bias for stocks based on their Credit Informed Tactical Asset Allocation Model. The framework compares the perspective of a credit index with an equity index (a stationary non-USD-numeraire mean-reverting index with a USD-numeraire index) to generate signals for asset allocations. Currently, as the chart indicates (the level of disconnect is negative - equity expensive) and as we have also noted for months, credit markets are notably more worried at the reality of our situation (and perhaps more so in real and not just nominal terms) than stocks.

 

In summary, adjusted for volatility and draw-down stocks are simply not as attractive from a relative-value perspective currently. Cyclically adjusted, credit markets are also priced for more concern than stock markets and thus either suggest being market-neutral in stocks (if forced to hold) or buying high-yield bonds (if bullish as they are priced 'cheaper' than stocks).

 


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Fri, 01/06/2012 - 15:53 | Link to Comment uno
uno's picture

infinite printing press for the markets

Fri, 01/06/2012 - 15:56 | Link to Comment Comay Mierda
Comay Mierda's picture

now for the kicker - price all of this shit in gold

Fri, 01/06/2012 - 17:26 | Link to Comment LowProfile
LowProfile's picture

lol!

Fri, 01/06/2012 - 18:38 | Link to Comment vast-dom
vast-dom's picture

I still can't believe that bonds are attractive, irrespective of insane yields and ZIRP! Sheer madness in the markets with funduhmentals essentially negative............the real kicker is that gold and silver aren't allowed to price anything due to blatent manipulation.....IQuit!

Fri, 01/06/2012 - 23:34 | Link to Comment Rynak
Rynak's picture

Worst of all evils for daytraders, is my answer.

Yeah, the bonds may be impossible to be paid in the long run, without issueing.... more bonds, to pay the earlier bonds..... yeah, someday a major correction will happen one way or another (question is just who's going to pay the bill.... and who's going to pay the bill of the bill shortly afterwards)....

But if all one cares about.... assuming one already aborted common sense, reason, mid- and longterm market outlook..... actually, any integrity beyond "what will prices be in 48 hours?"....... then YES, bonds actually are the least volatile investment..... they will consistently perform bad, rather than good or horrible.... until the day they don't work anymore.... but that's not a matter of 48hours for now.

TL:DR: Bond attractivity isn't about optimisim. it's about global desperation: PLEASE let me lose just a little bit short-term, and i'll accept the deal!

Fri, 01/06/2012 - 16:00 | Link to Comment Lets Hang Parliament
Lets Hang Parliament's picture

"credit markets are notably more worried at the reality of our situation"

but not nearly enough....

Fri, 01/06/2012 - 16:03 | Link to Comment Schmuck Raker
Schmuck Raker's picture

Posts like this are what make ZH my reality filter of choice.

Fri, 01/06/2012 - 16:09 | Link to Comment Contra_Man
Contra_Man's picture

For the tenth time.., "Markets" aren't ALLOWED TO BE Markets.   Smokin' em outta the VIX and MMF's are next IMHO.

Fri, 01/06/2012 - 16:08 | Link to Comment Stax Edwards
Stax Edwards's picture

Half a billion $ inflow into HYG in the last week.  HYG units outstanding have grown by 4.8%.

 

http://www.forbes.com/sites/etfchannel/2012/01/05/hyg-etf-inflow-alert-3/?partner=yahootix

Fri, 01/06/2012 - 16:12 | Link to Comment TooBearish
TooBearish's picture

ya BAC 5yr gives 5% or btr YTM ifn u wanna make that gamble

 

Fri, 01/06/2012 - 16:36 | Link to Comment I am a Man I am...
I am a Man I am Forty's picture

once again, entry point is everything

Fri, 01/06/2012 - 16:57 | Link to Comment CvlDobd
CvlDobd's picture

False, it's the exit.

Fri, 01/06/2012 - 17:50 | Link to Comment I am a Man I am...
I am a Man I am Forty's picture

exit is second most important, but if you are buying for a dividend, entry is everything

Fri, 01/06/2012 - 16:39 | Link to Comment I should be working
I should be working's picture

Admittedly stocks are not cheap, however, bonds as an asset class are the highest price they have ever been.  I have been lectured by friends who lost money in the dot com bust and now are 100% invested in bonds.  You have traded one historical peak valuation for another.  Buying when prices seem like they can only go up is a mistake, as is buying only one asset class.

Fri, 01/06/2012 - 19:03 | Link to Comment sneering nihilist
sneering nihilist's picture

"bonds as an asset class are the highest price they have ever been."

 

can you back up this claim? ust's are ridiculously expensive but i don't think us ig and us hy are. no froth in the us hy and ig markets yet, still time to buy.  tyler -- no more articles on corporate debt for a few more months, eh? i'm not done building my position. nah, seriously, thanks for posting this stuff!

Sat, 01/07/2012 - 01:30 | Link to Comment I should be working
I should be working's picture

Maybe I should have been more specific, Treasuries are at record high prices. The ten year T note hit a record low last year (as did just about every part of the curve). Lowest since WWII and still under 2%.  I still like munis - they were so oversold a year ago that the prices have only just gotten back to where they were - so a good mutual fund will give 4-5% tax free.  Investment grades are very low yielding, but I'm not sure where the historic low is.  You won't get much more than 4% before tax, which is underperforming inflation after tax.  And remember some will default so some of the yield needs to be reinvested, esp on high yield.

The game is rigged so that the stock market is the only place you have a chance of keeping up with inflation.  Personally, I'm about 33:33:34 stocks/bonds/cash and hoping for lower prices.  S&P 500 breaks under 1000 and I would raise that up a good bit.

Bonds are nice, but unless you're nearing retirement they aren't yielding enough to maintain purchasing power.  And bear markets can visit bonds too, it's just that no one investing now is old enough to remember the 70s.

Sat, 01/07/2012 - 10:50 | Link to Comment Lilguy
Lilguy's picture

Whether or not one agrees with these guys, at least they are looking at both sides of the equation--risk AND return. 

 

...I happen to generally agree with them and have so invested.

Sat, 01/07/2012 - 14:16 | Link to Comment I should be working
I should be working's picture

I don't think investing in something because it was less volitile in the past is a winning plan. The VIX looked calm until August last year, was that a good time to buy stocks?

I have wondered about the bonds vs stocks question myself, but more in the context of growth than volitility. If the US can't grow like it used to that will pull down the spread between bond returns and stocks going forward. In other words the less growth, the less you are compensated for your risk going forward.

But like I said bonds don't recover inflation BND yields 3.15%. And the average bond fund gained 7%, where did the extra come from - capital gains, which a buyer now will have to lose if the yield ever goes up.

Treasuries especially look like a bubble to me. And every bubble looks like smooth sailing and volitility is low, until one day it's not. Looking at the past can't tell you when (if?) that day will come. Look at MF Global, I'm sure they had a team of risk management people saying they could be just this leveraged on Italian paper to get the best return.

Right now nothing looks cheap, but stocks look cheaper than bonds to me. Unfortunatly my 401k doesn't have any options besides a broad fund of bonds. HY and investment grade look better than most.

Mon, 01/09/2012 - 01:45 | Link to Comment sara29
sara29's picture

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