The debate rages on, and it is between whether to invest in corporate bonds or equities, or if economic conditions are deflationary or inflationary? FT Alphaville, Fortune.com and Capital Spectator have covered this quite well. Here are all the pieces:

Of Bonds and Stocks and the Weimar Republic
(FT.com/Alphaville, March 30, 2009)
by Tracy Alloway

You’d have to be living under a bailout-sized rock not to be aware of the current debate surrounding equities vs corporate bonds.

HSBC has now thrown its hat in the ring, in a 24-page research note entitled “The triumph of the pessimists”, which looks at the behaviour of corporate bonds and equities over the past 140 years or so. Here’s the summary.

Lots of studies have looked at government bond and equity valuations, few at the relationship between corporate debt and equities. We’ve filled the gap, going back to the middle of the 19th century.

The results don’t look pretty for equities, which are likely to suffer a multi-year downgrading compared with corporate debt… Historically, there have been three multi-decade periods. Relative prices in the first two were very different to those in the third. Before the beginning of the last century, yields on corporate equity were sometimes lower than those on corporate debt and sometimes higher.

Over the following 50 years — from about 1907 until 1951 — they were almost always higher, sometimes a great deal higher. But for the 50 years starting in the early 1950s, dividend yields on equities fell sharply relative to yields on corporate bonds. By 2000, the peak of the cult of the equity, the relative yield of equities compared with government and corporate bonds had reached its lowest level ever.

In fact, the only significant period in which dividend yields weren’t higher than corporate bond yields was in the early 1930s (chart, using railway bond yields as a proxy for corporates, below), when dividend yields collapsed and corporate bond yields surged because of the cascade of Depression-related defaults, according to HSBC. Investors’ enthusiasm for equities was dulled, and, in a parallel with our current financial crisis, their appetite for corporate debt sharpened. Even as the economy improved and profits rose, investors attached an increasingly low valuation to dividend payments, resulting in increased dividend yields.

Fearing another depression, then, investors demanded more of their returns upfront. That’s why dividend yields went up and corporate spreads went down. Although stocks went up and down, the shift continued until 1950, by which time the trailing PE for the S&P had fallen to 6x, its dividend yield had reached 7.5%, yields on Baa bonds had fallen to 3.2% and spreads to less than 80bps. In the early 1930s, Baa yields reached 11% and spreads touched 725bps.

That was the cheapest that equities have ever been against corporate bonds. Over the next 50 years, not all at once and with big, sometimes huge setbacks, valuations of stocks compared with corporate bonds moved from their cheapest ever to their most expensive. Which … is the situation in which we find ourselves now.

Which leads us to today, when, according to HSBC, we’re facing two scenarios for corporate bonds and equities.

Over the past 18 months, the implosion of the global financial system has led to huge risk aversion and acute deflationary concerns, both of which have driven government bond yields lower still. Now, it could be that quantitative easing by central banks will lead to a pick up in inflationary concerns and worries about how governments will repay the huge numbers of bonds that they have issued and will continue to issue. That’s certainly not an argument that one should dismiss out of hand. That wouldn’t augur well for government bonds in the long term.

Alternatively, the situation we’re in now might echo the 1930s, when risk appetite was shot to pieces and, regardless of whether inflation fell through the floor or picked up somewhat, government-bond yields fell and then fell further. For their part, having spiked up hugely, corporate spreads declined for the rest of the decade. But as we saw earlier, if investors lapped up bonds, particularly corporate bonds, they shunned equities; earnings yields and dividend yields rose dramatically. In that environment, investors, in other words, were expressing a strong preference for safety and income over risk and capital gains.

Although we strongly suspect that the present world looks more like the second of these scenarios than the first, we really don’t know for sure. Perhaps it doesn’t much matter, as long as governments don’t unleash another huge inflation. For what is certainly true is that central bankers have now told us explicitly that they will not allow government bond yields to rise for the foreseeable future. Their aim is simple: to make risk-free assets so unattractive that investors wade into riskier markets, thus restoring confidence to the financial system and the economy as a whole. For now, it’s clear, equity markets have taken the hint, but corporate credit markets haven’t. That situation will, we think, be reversed.

This is a sentiment echoed in The Aleph Blog and Crossing Wall Street. The spread between corporate bonds and equities is getting big - corporates were sitting out of the recent rally. They are, as per HSBC’s research title, the pessimists.

However, as HSBC also notes, this is essentially a deflationary vs inflationary debate. In a deflationary environment, as in the Great Depression, corporate bonds, with their stable returns, make sense. In an inflationary environment those fixed returns are eroded. Equities, with their ability to raise prices in tandem with inflation (or as close as they can get) could be more attractive.

A slightly random example here - but the German stock market of the 1920s increased by a staggering amount as inflation shot through the roof. We’re far from hyper-inflation, but throwbacks to that era, like the below 1921 clipping from the New York Times, should give us pause for thought.

Related links:
Sunday links: Stocks vs bonds - Abnormal Returns
Is it back to the Fifties? - FT
Equity lives! - FT Alphaville
The death of equity - FT Alphaville

This entry was posted by Tracy Alloway on Monday, March 30th, 2009 at 16:32.

WHAT ARE MONEY MANAGERS THINKING? (Capital Spectator)

What are professional money managers thinking these days? A new poll by Russell Investments offers an answer. Among the highlights:

- 67% of managers are now bullish on corporate bonds
- 61% are bullish on high-yield bonds

In both cases, the percentages are a bit higher compared with the previous poll from last December. "In this environment of caution and realism, managers are finding opportunity in spreads between high-quality corporate bonds and Treasuries that are at historic levels," Erik Ristuben, Russell's chief investment officer, says in the accompanying press release. Expectations for junk bonds are also higher from late last year.

U.S. equities, on the other hand, have fallen in the eyes of managers. Value and small-cap equities suffer the most in terms of the current outlook, according to the Russell survey. Here's an overview of how the changes in expectations for the various asset classes stack up:

Source: Capital Spectator

High-yield bonds: Appetite for risk

If you've got the stomach for it, industry watchers say now is the time to hit the bargain buffet.

By Beth Kowitt, reporter

Last Updated: March 30, 2009: 12:02 PM ET

NEW YORK (Fortune) -- Like most investments with higher credit risk, the high-yield bond market took a huge hit in 2008 as investors fled to quality. But with the sector recently seeing its deepest discount ever - and even rallying a bit - some say it's time to test the waters again.

"The values are just extraordinary," says Martin Fridson, CEO of Fridson Investment Advisors and a high-yield bond specialist. "I think it's an opportunity you're not going to see very often in your lifetime."

Fridson says the spread between high-yield bonds and treasuries over the last few months has been far beyond anything seen before. The option adjusted spread, which measures the difference, is about 17.6 points, according to Merrill Lynch data. A year ago, the spread was 8.2 points.

Lower valuations mean more upside, Fridson says, but they're also the reason for investors' hesitations. Default rates will likely run higher than during past recessions, he notes, partly because the quality of the sector has deteriorated since the last low cycle.

Lawrence Jones, associate director of fund analysis at Morningstar, said some experts he's spoken with expect default rates, which have run between 2% and 3% the last few years, to reach between 10% and 15%.

"I see the opportunity," Jones says, "but almost everyone who's being straight with you will say there's a lot of risk."

You may know them as "junk"

High-yield bonds, or "junk" bonds, are defined by the industry as a bond with below a Standard and Poor's BBB- rating. They have a higher risk of default (failure to make a scheduled interest or principal payment), and are subject to greater price swings than more highly rated bonds. But on the upside they also have a higher rate of interest.

Jones suggests making high-yield bonds a small part of your portfolio through bond funds run by experienced managers and research teams investing in better-quality high-yield securities. A fund provides the advantage of a manager's expertise and also the diversification that's needed to limit the risk of default in any single investment. And high-yield bonds can be highly illiquid, i.e., hard to unload if they're thinly traded, but a fund gives you the security of getting in and out when you want.

Read the entire piece here.

Source: Fortune.com