High yield bonds – there are two parts to the story: the spreads are so tight that it makes them bad value, but tighter spreads mean great things for earnings and equities.
The first part of the story is that you as an investor are perhaps taking more risk than necessary in high yield bonds. Here is the spread for high yield bonds (the spread is the amount of interest that you are getting over ‘risk free’ returns). The spread is the tightest we have seen since 2007. And what this means is that even though high yield bonds have a good yield, they do not have great value here. There are much better places to invest in bonds that have a good yield AND good value.
Source: Charlie Bilello, as of 10/28/24
The second part of the story is that corporate America should have a great year according to bond investors. This chart (below) from Ned Davis Research shows the difference between high yield spreads and investment grade corporate spreads. As the red line moves higher, high yield spreads are tightening faster than corporate bond spreads, which means that credit investors are buying riskier bonds. Historically, this has been a good leading indicator for earnings growth over the next year. Year-over-year earnings growth for the S&P 500, the blue dashed line, is 8.2%, but they are set to move much higher if bond investors are right to be this optimistic.
Source: Ned Davis Research, as of 9/30/24
That is exactly what equity analysts are expecting for 2025. S&P 500 companies are expected to grow earnings by 15.2% led by health care and technology companies. Over the first two years of this bull market, stock prices have risen because stocks were getting more expensive. However, now is typically the time when earnings drive stock prices higher. And 15% earnings growth would lead to another good year for stock returns in the 3rd year of this bull market.
Source: Factset, as of 10/28/24
Sean Dillon, CMT, CFTe
SVP, Investment Strategy
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