Junk Bonds are Overvalued

Floyd Norris of the New York Times had a good piece on his blog last week comparing the relative valuation of high yield bonds to stocks.

Junk bonds have sold briskly in recent years as investors scramble to find yield wherever they can.

In a marked contrast to the stock market - where the constant chorus of the gloom and doom crowd rings loud and clear - few seem to be all that worried about credit risk.

But they should. 

To state the obvious:  junk bonds pay high rates of interest because they carry a significant risk of default. And today the additional yield paid to junk bond investors relative to their higher quality brethren is near all-time lows.

Here's an excerpt from the article that Norris wrote for the Times last week:

The perceived frothiness of the high-yield market would seem to be illustrated by the relatively low difference — or spread — between the yields on junk bonds and on United States Treasuries. At the end of the first quarter, it was 4.86 percentage points, well below the historical average. 

Moreover, the yield on Merrill Lynch’s index of lowest-quality junk bonds — those rated CCC plus or lower by Standard & Poor’s — is 9.3 percent, only a few basis points higher than the record low set in spring 2007, as credit markets were about to fall..

http://www.nytimes.com/2013/04/06/business/economy/junk-bonds-gain-popularity-even-as-yield-falls.html?_r=0

In his blog, Norris compares the earnings yield of the S&P 500 to the yield on junk bonds.  Not surprisingly, it turns out that on a relative basis stocks screen much better than high yield.
 
Here was the chart from Norris's blog:




As he wrote in the blog: 

As I talk to people these days, there seems to be widespread conviction that stocks are expensive, and that getting into the market now is highly risky. After all, the Dow Jones industrial average and the Standard & Poor’s 500-stock index have risen to nominal record highs at a time when the American economy is hardly putting on an inspiring performance and Europe continues to stumble along. 

Somehow people are not impressed by the fact that the S.&P. 500 has earnings that are about 80 percent higher than they were in 1999, when the index reached levels almost as high as those reached this year. 

http://economix.blogs.nytimes.com/2013/04/05/based-on-relative-yields-stocks-look-cheap/