as part of our
Legendary bond investor, Bill Gross, just released his
for March. As always, it's a loaded read.
Some have been hailing it as a warning against a bubble in
high-yield corporate debt, which Gross expresses concerns about.
But as you'll see in a moment, the argument is more nuanced than
He also uses that information to conclude that we're in store
for years of low-equity returns - which is off point
First, let's start with the bubble…
Gross' Bet on a Baby Bond Bubble
Gross uses a
by Fed Governor, Jeremy Stein, to investigate the question: "How
can we tell when prices have reached a bubble level?"
The asset in question is high-yield corporate debt.
Now, it's clear that "high yield" has become "not-so-high
yield." In the search for income, investors have bought up
corporate bonds, driving prices up and yields down.
But while yields are lower than normal, we haven't quite reached
Since 1996, high-yield (or junk) bonds, have returned about
5.99% more than government bonds, according to the Bank of America
Merrill Lynch US High Yield Master II Index.
That average also includes the highly skewed period of 2008,
when the spread reached as high as 22%.
Today the spread is down to 5%. Bubble territory? Not so
likely that bonds need to fall from here. So I'll give him that
But his outlook on stocks is another story…
Why Stocks Should Still Rule the Day
Gross takes it a step further, citing a chart by the
always-insightful Bianco Research. It shows the correlation between
yields and equity prices.
Keep in mind that the yield line on this is inverted. So the
chart suggests that if yields on corporate bonds rise (as we are
predicting), then stock prices will fall.
Makes sense. You see, during times when money leaves corporate
bonds, it can be a flight to safety that would end up in
Treasuries. That money would similarly leave stocks, which backs up
But here's where I see the error.
That means stocks can also
during periods of flat or rising yields.
If you extend the timeframe on that chart (as I've done below),
you can see that while the correlation does hold true sometimes, it
also clearly breaks down at other times.
The key to this anomaly? Risk.
Each time this has happened in the past, it's been during
periods of rising risk appetite among investors: after the 1998
Asian fiscal crisis, during the dot-com boom and during the
Yes, two of those scenarios were the building of bubbles. But
all of them correlated with times when the investors' hunger for
risk rose substantially.
Why does this happen?
Well, when money leaves bonds during periods of heightened risk
appetite, it goes into stocks. So in these scenarios, stocks don't
fall when corporate bond yields rise, as Bianco's research
And I've been arguing that we're undergoing the same thing right
now. The risk-on/risk-off trade is dissipating. The financial
crisis is over. The European crisis is (mostly) resolved.
Simply put, the stock market is booming because investors aren't
afraid to take reasonable risks.
So far, this high-risk capital has been funneled into bonds
because they have offered the highest return available for a while.
That's why corporate bonds are likely priced too high at this time.
Prices will fall and yields will rise.
Only this time around, that money will flow into stocks, not
Bottom line: Don't consider this bond mini-bubble to be a bad
sign for stocks. I consider it just the opposite.