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The asset allocation choice between fixed income and equity involves the analysis of many factors including valuations, risk, volatility of returns, correlations, secular changes in investor risk appetite, policy initiatives and economic conditions. Given the recent sharp decline in equity prices, some investors are considering increasing their equity allocation. Although the recent drop in equity prices may require a rebalancing based on historical policy statements, investors should take into account the current opportunities in other market segments. Specifically, carefully selected high-quality credit currently offers significant value at the top of the capital structure, creating the potential for superior risk-adjusted returns relative to equity. This is particularly the case given the direction of government policy, economic risks and longer-term trends in investor preferences toward safety, income and preservation of capital.

High-quality investment-grade corporate bonds now offer expected returns at levels normally associated with equities. In addition, credit can be considerably less risky than equity, particularly amid the economic and deleveraging risks that are growing as an increase in the public sector’s wallet is being offset by the private sector’s lack of will. In this environment, equity returns will not likely recover until the credit markets recover. Tight credit conditions should further support the premise that lenders will benefit relative to owners. For these reasons, we believe that investors should buy credit now, and equities later.

Relative and Absolute Valuations Favour High-quality Credit
Tight credit and financial conditions have caused a significant economic slowdown, but they have also created significant relative value and absolute value opportunities for investors. The US economy is in recession and deflationary risks are rising, causing high-quality credit spreads to trade at their widest levels in 75 years.¹ A diversified basket of investment-grade corporate bonds now yields roughly 8%.² In contrast, the earnings yield on the S&P 500 index is now less than 6%.³ High-quality corporate bonds have cheapened to the point where investors can now actually pick up yield by moving up the capital structure.

On a relative basis, high-quality corporate bonds are likely to outperform equities over the near term. Why? Stock prices should track earnings growth and dividend trends. Historically, profits grow at roughly the same rate as nominal gross domestic profit (GDP) growth, which is likely heading towards zero growth on a year-over-year basis. The dividend yield on the S&P 500 is now 3.8%.⁴ So, assuming no change in multiples or dividends, the stock market would deliver low single-digit returns with flat earnings growth. Yet we do not consider current stock valuations to be cheap with multiples for the S&P 500 trading now at 17.3x actual earnings and 10.5x forward estimated earnings.⁵

Additionally, equity analysts have continued to underestimate the impact of trends in the credit markets and, as such, have consistently revised down earnings guidance. Should analysts’ earnings estimates continue to get revised down, as is likely, stock prices could come under further pressure. Historically, stocks have tended to trough at roughly 7x earnings versus the current level of 10.5x earnings. So even if equity analysts are correct in their estimates, stocks still aren’t cheap relative to historical trough price-to-earnings multiples. And most importantly, stocks are unlikely to start recovering until credit markets recover, particularly given the rising risk of deflation, continued financial market deleveraging and economic uncertainty.

While stocks may not be “cheap,” high-quality credit is now attractive on both an absolute and relative basis (Chart 1). With credit spreads of +534 basis points over Treasuries and roughly 8% yield levels for the overall investment grade corporate bond market,⁶ we have been selectively buying bonds in high-quality credits closest to the handle of the government’s policy umbrella, including banks and non-bank financials that are receiving direct capital injections. These companies’ bonds, rated mostly low AA to high A, are yielding approximately 8-12%, representing significant value and an attractive risk/reward profile versus equities in the current economic environment.

In terms of default risk, the current realised overall corporate default rate including investment grade and high yield is just over 1%.⁷ This level of defaults is still very low relative to historical peaks of roughly 4% in 1991 and 2002, and it will rise. Still, current credit spreads suggest that the market is fearing a more severe outcome. Assuming a 40% recovery rate on senior unsecured investment grade bonds, the current implied investment grade default rate at current spreads is close to 9%.

Investment-grade credit spreads are currently +534 basis points over Treasuries whereas in January 1991, spreads peaked at 154 basis points and in October 2002, spreads peaked at 224 basis points.⁸ High-quality investment-grade corporate bond spreads are very wide now with respect to actual investment-grade default rates, which are now running at 0.3% (Chart 2). While it is likely that the default rate will increase as the economy weakens, we believe that lower-quality companies with weak balance sheets will likely be hit significantly harder than higher-quality companies and current high-quality spread levels provide investors with attractive compensation for the risk assumed.

Relative levels of volatility also favour credit over equities. The volatility of returns in the investment-grade credit market is roughly one third of the volatility of equity market returns (Chart 3). Over the past twenty years, the S&P 500 has returned only 2% more than the investment-grade corporate bond market, yet with nearly three times the volatility. As a result, high-quality credit has historically offered investors superior risk-adjusted returns versus equity (Chart 4).

Going forward, we expect high-quality credit to continue to perform well versus equity for the following reasons:

• Financial market deleveraging should put pressure on asset prices and owners of risk assets
  
  
• Consumer deleveraging will likely lead to continued weak economic growth and favour lenders
  
  
• Tight credit will likely motivate management to emphasise balance sheets relative to growth
  
  
• A prolonged recession and/or deflation could lead to asymmetric risk for equity holders
  
  
• Dividend cuts are increasingly likely as companies attempt to preserve cash and liquidity
  
  
• Investors are turning more conservative and looking for principal protection
  
  
• Pension funds’ need to immunise liabilities should contribute to demand for long duration credit
  
  
• Demographic trends suggest aging populations will turn towards safety in high-quality bonds
  
  
• Investments high in the capital structure historically offer superior return per unit of risk
  
  
• Policy initiatives to support economic growth are likely to favour bondholders relative to equity

We can now explore the details of current policy initiatives and the outlook for economic growth, two factors which shed considerable light on whether or not it is better to be a lender (bondholder) or owner (equity holder) in today’s environment.

Policy Initiatives Favour Bondholders
Given the current credit crunch, policy efforts globally are being directed to help recapitalise the banking system. In the United States, these initiatives have constantly evolved over the past several months. For example, the Troubled Asset Relief Program (TARP), which was originally set up to buy distressed assets from banks, is now being used to purchase preferred capital of banks and a select group of non-bank financial companies. The Treasury’s shift from buying distressed assets to investing directly in financial firms has had some striking, yet likely unintended consequences. The government’s investment in preferred capital is now senior to common equity in the capital structure, which is positive for senior and preferred bondholders of these companies but dilutes equity holders. The recent widening of spreads for commercial mortgage-backed securities (CMBS) is one example of the Treasury’s unintended impact. Investors in leveraged, distressed securities now see less support, whereas senior bondholders of banks and a select group of non-banks stand to benefit.

As the Federal Reserve continues to expand its nontraditional policy measures, we may see a further expansion of the Fed’s balance sheet through either direct purchases of assets or guarantees.  In terms of direct purchases, the Fed will likely target directed purchases of senior debt in the mortgage market in order to help stabilise the markets and bring down mortgage rates for home buyers. Guarantees of assets on specific company balance sheets may continue on a case by case basis, but the Fed (and Treasury and FDIC) are likely to require that any firm getting specific guarantees on assets must take first loss positions as a condition to providing support. In both cases, the Fed’s and government’s support should help in stabilising the credit and financial markets, but be more favourable for investments at the top, as oppose to the bottom, of the capital structure.

“Wallet Without Will” Favours Lenders, Not Owners
There are other reasons why lenders (bondholders) may prosper relative to owners (equity holders) in this current economic environment. Government efforts to help recapitalise the banking system may take some time to work. In this economic cycle, tight credit and financial conditions have caused a significant slowdown in the economy (Chart 5). While the private sector is retrenching, the public sector is increasing its role in helping to support the economy. Yet, wallet without will is a problem. The public sector may have a substantial wallet, but without the private sector’s will to spend it or invest it, the economic recovery could be subpar, resulting in bondholders continuing to benefit relative to equity holders.

Another significant factor in the current economic cycle is leverage. Where are we? The private sector – both businesses and consumers – is being forced to deleverage amid the economic slowdown. And while the government is recapitalising the banking sector, banks do not yet appear to be recirculating the money back into the real economy. Why? Because banks are cautious and tightening their lending standards given the potential for additional write-downs if and when the economy deteriorates further. In addition, as we described in our October 2008 US Credit Perspectives, “Trick or Treat?” banks are increasingly facing unforeseen and unwanted draw downs on revolving lines of credit as companies tap their bank lines due to an inability to get funding from the capital markets. With the economy deteriorating and bank lines being drawn down, the banks are less willing to recirculate capital back into the economy. Wallet without will is both a cause and effect of deleveraging in the private sector.

It turns out that the banks are not the only players without will in today’s economy. Consumers also lack will (and confidence) given rising unemployment, tight credit, lower housing prices and falling stocks. With asset prices falling, banks are tightening credit to consumers. As such, consumers have not only lost the will to spend, but now also, the wallet. This transition from consumers using rising asset prices to support spending, to consumers having to deleverage as asset prices fall, ultimately means that less money is being spent. As consumers deleverage and spend less, corporate profits and overall economic growth slows. This is important, because in the most recent economic cycle, rising asset prices supported the willingness to take risk and fed ”animal spirits,” which led banks to lend and consumers to spend. As spending increased, corporate profits rose, jobs were created and capital spending increased, which resulted in the private sector’s will to spend.

However, with asset prices now falling, banks are tightening credit and mortgage debt growth is slowing sharply, leading to a pronounced decline in economic growth (Chart 6). The private sector’s wallet is shrinking as asset prices fall, risk appetites decline, and balance sheets are deleveraged. In this process, consumer spending has slowed and businesses are generating less profit, which in turn lead to less hiring and capital spending. Through this deleveraging transition, both consumers and businesses lack the will to spend. So, while the government’s wallet is being used to ensure solvency in the banking system, economic growth will remain constrained by the private sector’s lack of will to spend.

Lending Is Attractive Versus Owning
The investment implication of transitioning into an economic environment of public sector wallet without private sector will is that bondholders are likely to continue to benefit relative to equity holders. Simply put, investors today are better off lending at the top of the capital structure than owning at the bottom of the capital structure. As discussed above, deleveraging leads to weak economic growth which should result in corporate profits remaining poor. Profits tend to lead job creation by about nine months to one year (Chart 7). As a result, the sharp slowdown in profit growth over the past few quarters implies that the unemployment rate should head materially higher over the next year, which should result in consumer spending remaining weak. Corporate profit margins should therefore come under considerable pressure over the next year as employment conditions deteriorate (Chart 8).

In addition to rising unemployment, businesses also have to worry about the high cost of capital. Tight credit and financial conditions mean investment grade companies may pay 8-12% and high yield companies could pay up to 20% to access new capital. High costs of capital lead profit margins to come under further pressure. Equity prices simply won’t recover until the cost of capital falls and credit markets recover. Also, banks have tightened credit in this economic cycle ahead of a material rise in the high yield default rate (Chart 9). While unusual, the fact that banks and investors in the capital markets have significantly tightened lending standards means that many companies with high leverage and weak balance sheets will end up going into default. Moody’s projection is for the high yield default rate to rise to over 10.4% over the next 12 months.

Investors should continue to avoid buying equity in highly leveraged companies given the current fundamental and technical environment. On the fundamental side, tight credit conditions and further deleveraging in the real economy mean owners of levered assets will continue to suffer at the expense of senior lenders. Senior bondholders and banks are likely to get additional security on assets in the form of covenant protection. A weak and deepening economic slowdown also means equity holders may face an increasing likelihood that companies will cut dividends to maintain necessary liquidity in an environment where capital markets remain closed to all but the highest quality companies or those that are likely to receive government support.

The bottom line is that any asset or company which is highly leveraged in today’s environment remains at risk. Real estate prices will likely continue to fall and equity prices for leveraged companies will likely remain under considerable pressure. With high quality corporate bonds yielding 8% and longer-term earnings growth tracking the trend in nominal gross domestic product (GDP), high quality corporate bonds look particularly compelling now relative to equities (Chart 10). Investors should move up in the capital structure into senior bonds if they have not already done so, and avoid any temptation to favour equity investment until credit markets recover. Ownership should eventually be lucrative, but lending is now more attractive than owning on a risk adjusted basis, given that financial markets and consumers are deleveraging at the same time credit conditions remain tight.

Credit Now, Equities Later
Credit markets led the downturn in this economic cycle and will likely lead an eventual upturn. The economy is transitioning from a world where rising asset prices supported higher debt levels. However, now that asset prices are falling, the private sector’s players – consumers and businesses – are being forced to deleverage, which will keep asset prices under pressure. Current and future policy initiatives are likely to favour bondholders and dilute equity. This environment is negative for equity holders, particularly because the tight credit environment should put pressure on companies to preserve balance sheet strength as opposed to paying dividends and growing capital spending. These conditions, combined with secular and demographic trends favouring principal protection and safety in high-quality investments, favour bondholders (lenders) versus equity (owners).

The government’s policy initiatives have created a public sector wallet to help support economic growth. Nevertheless, without the private sector’s will to spend and invest, a prolonged recession is increasingly likely, which would be negative for equity holders. Equities’ negative asymmetric risk profile in a deflationary environment is particularly concerning today, given the private sector’s lack of will to take risk. While fiscal and monetary policy initiatives should reduce the risk of deflation, without private sector will and easier credit conditions, investments at the bottom of the capital structure (equity) will likely continue to underperform high-quality bonds and investments at the top of the capital structure. As such, investors should consider high-quality credit now and wait to invest in equities later.

Mark Kiesel
November 22, 2008

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¹ Moody’s Investment Grade Credit Spreads, as of October 2008.
² Barclays Investment Grade Credit Index, yield (%), as of 11/21/2008. This index (formerly the Lehman Brothers Investment Grade Credit Index) includes publicly issued US corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered. The index includes both corporate and non-corporate sectors. The corporate sectors are
Industrial, Utility, and Finance, which include both US and non-US corporations. The non-corporate sectors are Sovereign, Supranational, Foreign Agency, and Foreign Local Government.
³ Bloomberg, as of 11/21/2008.
⁴ Bloomberg, as of 11/21/2008.
⁵ Bloomberg, as of 11/21/2008.
⁶ Barclays Investment Grade Credit Index, Option Adjusted Spread (OAS), as of 11/21/2008.
⁷ UBS, as of 9/30/2008.
⁸ Barclays Investment Grade Credit Index, Option Adjusted Spread (OAS).