Shares in American companies are the most expensive they have been in almost 20 years. Bonds from American companies aren’t even as expensive as they were this February. Are corporate bonds offering a bargain that the stock market isn’t?
Perhaps—but it isn’t as obvious as it looks. The problem is that comparing stock and bond valuations is like comparing apples and orangutans: they just have very little in common. U.S. stock indexes are stuffed with companies that investors currently want, led by the giants of Microsoft Corp,, Apple Inc. and Amazon.com Inc. Bond indexes are full of indebted businesses no one likes, especially heavy industry and oil-and-gas companies.
The valuation gap between the benchmarks is huge. The S&P trades at 22 times its estimated operating earnings for the next 12 months, the highest since 2001. It has been more expensive only 6% of the time since data began in 1985, according to Refinitiv. By contrast, investment-grade bonds have been more expensive almost half the time since the ICE index started in 1996, and junk bonds have been more expensive almost two-thirds of the time, both measured by the spread of their yields above similar-maturity Treasurys.
One reason: Technology stocks make up more than a quarter of the main stock index, the S&P 500, but only 8% of the ICE BofA US Corporate index, one of the investment-grade bond benchmarks, and only 5% of the equivalent high yield, or junk bond, index. Energy and materials stocks make up 5% of the S&P, but 14% of investment grade and an enormous 23% of junk. At a time when tech is in favor and oil is out of favor, indexes that lean to tech are almost bound to be more expensive than those that lean to energy.
“When I think about the S&P, I would consider that a higher quality index than high yield on average so it’s hard to compare one-for-one,” says Thushka Maharaj, global multiasset strategist at JP Morgan Asset Management. “The S&P does look expensive but once you adjust for the tech [valuation] it is more reasonably priced.”
Just how hard it is to compare bonds and equities overall can be seen by looking at the technology sector itself, where again highly rated stocks such as Apple and Microsoft matter more to the equity index than the bond index. Companies that have more weight in the S&P tech sector than in ICE’s bond sector trade at 26 times estimated earnings, against less than 15 times for companies where the bonds are given more weight than the stock (examining only companies that feature in both indexes).
To put some names on it: Lowly-rated Oracle, IBM and Intel are as important in the tech-sector bond index as Apple and Microsoft, while in the stock sector the two tech giants have six times the weight.
This isn’t just caprice on the part of the index compilers. The measures are capturing a deep difference in the market. Stock gauges give more weight to companies with more equity value, while bond gauges give more to companies with more debt. At a time when investors are worried about leverage, it shouldn’t be a surprise that companies with more debt are unpopular.
Still, split out the lowly-rated companies—many of them leveraged buyouts—or the energy stocks and corporate bonds still look fairly cheap compared to history. Corporate bonds in each rating from AAA down to CCC have been cheaper half or more of the time since 1996, showing the cheapness isn’t only about quality.
Gregory Peters, head of strategy at PGIM Fixed Income, says investing when corporate bonds are this cheap has typically worked out well in the past. “We’re in a golden age of credit,” he argues. “In an environment where debt levels are high and there is slow growth as far as they eye can see, dividends are being cut and investment canceled as companies are looking to preserve free cash flow. That’s a bond story not an equity story.”
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It could be that both stories are true. Companies facing tough business conditions are likely to prioritize meeting their debt repayments, reducing the cash available to spend on growth or hand out in dividends. For those companies, it should be better to hold the debt than the stock—and any sign that the economy will avoid even more serious trouble that could send the companies into bankruptcy should help the bonds move back up toward their pre-coronavirus valuations.
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But there is a bunch of big companies that investors think can keep growing, despite lockdowns, and they tend not to be highly indebted. These companies—Microsoft and Apple among them—have spare cash to lavish on their shareholders, both by investing in profitable projects and by paying dividends. They need to get a lot right to justify their high valuations, but it’s easy to see why they are so expensive.
Stock gauges give more weight to companies with more equity value, while bond gauges give more to companies with more debt.
Photo: Michael Nagle/Bloomberg NewsWrite to James Mackintosh at James.Mackintosh@wsj.com
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