Across the Standard & Poor’s 500 Index, evidence has surfaced that the stresses that blew into credit markets this summer have changed the way Americans view stocks. For one of the few times since 1996, companies whose bonds are rated investment grade are trading with higher price-earnings ratios than those rated junk.
Concern about credit quality provided the prologue to the stock market’s 11 percent decline in August and, unlike the swoon itself, it has not gone away. The flip-flop in valuations highlights newfound caution among investors who for most of the past two decades paid more for junk-rated companies, convinced they would grow faster, while falling rates kept solvency concerns at bay.
“As the recovery starts to show age, the risk of recession starts to rise and the last thing you want to be in as you head into a recession is low-quality rated companies,” said Jim Paulsen, the Minneapolis-based chief investment strategist at Wells Capital Management Inc. “We had a fairly significant increase in credit spreads for the first time in a while, which would tend to alter valuations in the stock market.”
Among stocks, the average P/E ratio for companies with high-yield bonds slid to 15.5 at the end of last month from 16.8 in January. On the other hand, valuations for investment-grade firms climbed to 16.2, leaving them near the biggest premium to their junk-rated counterparts since 1996, data from Bank of America Corp showed.
Investors usually confer higher multiples on lower-rated companies. Since 1996, the average price-earnings ratio for stocks with a speculative credit rating has been 1.8 times that of investment grade, the data showed.
The premium reflects a superior earnings outlook: The 54 high-yield companies in the S&P 500 have seen profits rise at an annualized rate of 16 percent over the past five years, compared with 12 percent for 389 investment grade firms, data compiled by Bloomberg showed.
Appetites are changing following a three-year run in which companies that score lowest in measures of financial strength have consistently beaten their sturdier counterparts in the stock market. That is poised to end this year. A basket of companies with stronger balance sheets compiled by Goldman Sachs Group Inc is up 6.7 percent since December, compared with 4.3 percent for the weaker group.
Concerns about solvency might not be unwarranted. A total of 59 companies have missed interest payments, gone bankrupt or exchanged debt at a discount this year through Nov. 4, up from 28 a year earlier, according to S&P. It is the most for the period since the 180 registered in 2009.
The focus on credit quality is shifting in the equity market following a period when bond spreads widened amid expectations the US Federal Reserve would raise interest rates. The extra yield investors demand to own junk bonds has averaged 6.32 percentage points since the end of September, compared with 5.12 points in the year before. While the spread has narrowed since the start of last month, it remains higher than any time prior to early August.
The decline in valuations for stocks with high-yield bonds is simply a buying opportunity, according to a report from Goldman Sachs Group Inc. The rebound in junk bonds since the end of September may spur a catch-up rally in companies such as Ally Financial Inc, HCA Holdings Inc and Level 3 Communications Inc, it said.
Weakness in credit markets could endanger something else that has helped lift equities almost threefold since 2009 — corporate buybacks — and there are signs in the stock market that investors are preparing for that, too. Stocks with the highest buyback ratios are trailing the rest of the market for the first time after two years of outperformance.
Borrowing for buybacks has gotten so aggressive that for the first time in about five years, equity fund managers who said they would prefer companies use cash flow to improve their balance sheets outnumbered those who said they would rather have it returned to shareholders, according to last month’s survey by Bank of America.
“Equity investors care about company credit quality especially when there’s a concern about economic momentum,” said Jim McDonald, the chief investment strategist at Chicago-based Northern Trust Corp, which oversees US$946 billion. “When the economy slows down, the companies with worse credit quality would also probably see their stocks struggle.”
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