Junk bonds have been enjoying the limelight these days. Investors have shown less hesitation in adding junk bonds to their portfolios, especially given a low default rate and the historically low yields on Treasuries.
Interestingly enough, fears over volatility in equities and the low rate of default for junk bonds is leading to a disconnect between junk bond yields and equity valuations, says Pierre Lapointe, global macro strategist at Brockhouse Cooper. And it’s creaated a very unique situation.
“The spread between the yield on global junk bonds and the 12-month forward earnings yield on the MSCI World Index (i.e. the inverse of the forward P/E ratio), has turned negative for the first time since data are available on the topic,” said Mr. Lapointe in a recent note.
In short, this basically means investors consider the risk associated with company earnings in the next 12 months to be higher than the risk of default from holding junk bonds.
But there is also a sector story in the numbers. Mr. Lapointe examined which sectors had the highest yield spread between junk bonds and equities, and found that both energy and financials had equally high spread levels. It makes sense, considering investors in the U.S. are nervous over banks suffering from the current foreclosure mess there. Energy, meanwhile, is suffering uncertainty over a slowdown in the global recovery, and expectations of subsequent drops in demand for commodities like oil.
Mr. Lapointe suggests one way to avoid taking on too much risk is to pursue options in Canadian or Australian financial junk bonds, which can offer high yields but less of a chance of default. Energy, in contrast, should be viewed more broadly says Mr. Lapointne, considering Brockhouse Cooper has an overweight view on the sector, believing it will be boosted by expansions underway in the Asia Pacific region.
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