The decline in credit has been well publicized over the last several weeks, though this decline began months ago. Since the summer, we have seen spreads, a measure of valuation for the high yield market, widen from 400bps to 760bps1 to levels we have not seen for the last four years. High yield bonds are often thought of as a leading indicator for equities, meaning this segment of the market is usually the first to recognize problems and decline and then the equity markets eventually catch up. But so far, we haven’t seen a material hit to equity valuations.
As the charts below picture, over the past four years we have seen high yield bond spreads come full circle, putting us back at valuations not seen since the 2011 European crisis2, all the while equities have moved in pretty much a straight line up from P/E’s of 14x to right around 22x3. Keep in mind generally the higher the spreads (a measure of the yield to worst relative to comparable maturity Treasuries), the cheaper we would view the high yield market, while the higher the P/E ratio, the more expensive we would view the equity market.
By historical valuations, equities are more expensive compared to historical averages, meaning you are having to pay more for given earnings4, while the high yield market is cheaper, meaning you are getting a higher spread for your bonds relative to the historical averages.5
Interesting, these high equity valuations are in the face of estimates for S&P 500 earnings to decline -4.4% for the fourth quarter, the first time we have seen three consecutive quarters of year-over-year declines in earnings since 2009.6 This poses the question, if earnings are going to be negative, what is going to drive P/E ratios higher and give investors a positive return in the months and quarters to come? We are seeing growth decline across the board globally and don’t see anything to cause that to change over the coming quarters and maybe even years. We struggle to see how equity investors can justify a further increase in valuations, thus we don’t see much upside from current levels, and potentially even downside.
However, with the high yield bond market already in correction mode, at multi-year highs in terms of spreads, and what we see as over-reaction to current market and economic conditions, we believe there is attractive value to be. Unlike equity investors, we don’t have to bet on earnings growth or valuations to increase to drive P/E ratios and returns. We instead need companies continue to pay their bills and plug along to maturity to realize that ultimate value and return, as barring a default, bonds mature at par value if not called prior to that above par. From a credit perspective, we believe that fundamentals remain relatively solid and that active investors that can focus on the bonds they see as undervalued are very well positioned to extract that value from today’s high yield bond market.
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