JANUARY 17, 2009, 11:11 P.M. ET
How to Profit From the Credit Crunch
By MARK GONGLOFF
Investors shell-shocked by two nasty bear markets in stocks in less than a decade are starting to look elsewhere for good returns. In the wake of the worst credit crunch since the Great Depression, some analysts suggest they might take a look at, believe it or not, credit.
Their reasoning: Bonds and other credit instruments have arguably suffered much more than stocks during this downturn, meaning they could have further to climb when the economy starts to recover. What's more, as credit led the economy and stocks into the valley, it might have to lead them back out, meaning it could recover before stocks do.
Stocks "are historically first out of the block" in a recovery, says Binky Chadha, chief U.S. equity strategist at Deutsche Bank, "but given the credit crisis this time, credit has to recover before we can get equity returns."
Stocks took several steps back from a recovery last week, when the Dow Jones Industrial Average fell 3.7%. The blue-chip index is down 5.6% so far this year and 42% from its record high in October 2007. Last November, at the depths of the current bear market, the Dow was off 47% from its record, the worst decline since the 1930s.
But the suffering in the credit market has been unprecedented, as investors have come to avoid credit risk like poison. They have demanded record-high interest rates on debt, at levels that suggest a record wave of corporate defaults.
On the bright side, this offers investors a hefty yield -- even after a slight recovery in credit markets in recent weeks, which has pushed interest rates lower.
Many analysts say bonds still offer "equity-like" returns, but that may be underselling them: There is a chance some bonds can offer better returns than stocks.
'Astounding' Yields
For example, the yields on corporate bonds that ratings agencies consider below-investment-grade -- so-called junk bonds -- are 16 percentage points higher, on average, than yields on U.S. government debt of similar duration, according to Merrill Lynch data. A 10-year junk bond might yield 18%, compared with roughly 2% for the 10-year Treasury note.
That is an astounding gap; two years ago, junk bonds yielded just two percentage points more than Treasurys. This "spread" is not much lower than its record high of about 22 percentage points, set in November. Many analysts say this represents a much direr outlook for the economy and corporate bankruptcies than even the stock market does.
"Yield levels and the expected default rates they imply are way out of line with everything but a nuclear bomb," says Vinny Catalano, chief investment strategist at Blue Marble Research.
Safer debts have lower yields, just as more-creditworthy individual borrowers get lower rates when they apply for a loan. Bonds for companies with an "A" credit rating -- roughly middle of the pack for investment-grade bonds -- yield five percentage points more, on average, than Treasurys. Historically the spread is about one point.
Municipal bonds, which state and local governments use to pay for building bridges and libraries, yield nearly one percentage point more than Treasurys. Typically, given the rarity of municipal defaults and the tax-exempt status of their bonds, they yield slightly less than Treasurys.
These safer credit risks don't offer enormous returns, but if the stock market is flat, or worse, in 2009, then they could look much more appetizing. And despite a recent swoon, stocks could still be in store for a big disappointment if the economy fails to rebound sharply in the second half of the year, as many in the stock market still hope. Bonds, on the other hand, may already be priced for big disappointment.
No Certainty for Stocks
"We're really not even close to a point yet where we could state with confidence that equities will significantly outperform corporate bonds over the next six months," says John Lonski, managing director and economist at credit-rating agency Moody's.
But there are risks to wading into debt. If the economy roars back much more quickly than economists expect, bonds would still rally, but stocks might surge even more.
On the other hand, an economy that stays sluggish for a long time could spawn a growing wave of corporate bankruptcies that burn debt holders. What keeps policy makers awake at night is a worry that stimulus measures won't break the vicious cycle gripping the economy right now, in which tight credit hurts the economy, which hurts borrowers' ability to repay their debt and leads to still-tighter credit.
Even assuming some benefit from stimulus, Moody's expects high-yield-debt default rates to surge to 15% by the end of 2009, from just 4% at the end of 2008. That would be a record high for defaults in the modern era of junk bonds, which began in the 1980s.
Investment-grade default rates have been much lower, but will likely rise, as well. An economy that fails to respond to stimulus could push defaults still higher.
Meanwhile, some $758 billion in corporate debt is coming due in 2009, according to Standard & Poor's, meaning companies will have to either pay what they owe or refinance. Most of these debts were incurred five or 10 years ago, when rates were much lower, so refinancing will mean significantly higher borrowing costs for most companies. Less-creditworthy companies may not be able to get new financing at all. This increases the risk that companies won't be able to pay their debts.
In other words, very high yields on corporate bonds may be perfectly appropriate, given the risk that they could turn to dust in your hands. "It is still a very treacherous economic climate, and one has to proceed with caution" when buying debt, says Mr. Lonski.
Write to Mark Gongloff at mark.gongloff@wsj.com
How to Profit From the Credit Crunch
By MARK GONGLOFF
Investors shell-shocked by two nasty bear markets in stocks in less than a decade are starting to look elsewhere for good returns. In the wake of the worst credit crunch since the Great Depression, some analysts suggest they might take a look at, believe it or not, credit.
Their reasoning: Bonds and other credit instruments have arguably suffered much more than stocks during this downturn, meaning they could have further to climb when the economy starts to recover. What's more, as credit led the economy and stocks into the valley, it might have to lead them back out, meaning it could recover before stocks do.
Stocks "are historically first out of the block" in a recovery, says Binky Chadha, chief U.S. equity strategist at Deutsche Bank, "but given the credit crisis this time, credit has to recover before we can get equity returns."
Stocks took several steps back from a recovery last week, when the Dow Jones Industrial Average fell 3.7%. The blue-chip index is down 5.6% so far this year and 42% from its record high in October 2007. Last November, at the depths of the current bear market, the Dow was off 47% from its record, the worst decline since the 1930s.
But the suffering in the credit market has been unprecedented, as investors have come to avoid credit risk like poison. They have demanded record-high interest rates on debt, at levels that suggest a record wave of corporate defaults.
On the bright side, this offers investors a hefty yield -- even after a slight recovery in credit markets in recent weeks, which has pushed interest rates lower.
Many analysts say bonds still offer "equity-like" returns, but that may be underselling them: There is a chance some bonds can offer better returns than stocks.
'Astounding' Yields
For example, the yields on corporate bonds that ratings agencies consider below-investment-grade -- so-called junk bonds -- are 16 percentage points higher, on average, than yields on U.S. government debt of similar duration, according to Merrill Lynch data. A 10-year junk bond might yield 18%, compared with roughly 2% for the 10-year Treasury note.
That is an astounding gap; two years ago, junk bonds yielded just two percentage points more than Treasurys. This "spread" is not much lower than its record high of about 22 percentage points, set in November. Many analysts say this represents a much direr outlook for the economy and corporate bankruptcies than even the stock market does.
"Yield levels and the expected default rates they imply are way out of line with everything but a nuclear bomb," says Vinny Catalano, chief investment strategist at Blue Marble Research.
Safer debts have lower yields, just as more-creditworthy individual borrowers get lower rates when they apply for a loan. Bonds for companies with an "A" credit rating -- roughly middle of the pack for investment-grade bonds -- yield five percentage points more, on average, than Treasurys. Historically the spread is about one point.
Municipal bonds, which state and local governments use to pay for building bridges and libraries, yield nearly one percentage point more than Treasurys. Typically, given the rarity of municipal defaults and the tax-exempt status of their bonds, they yield slightly less than Treasurys.
These safer credit risks don't offer enormous returns, but if the stock market is flat, or worse, in 2009, then they could look much more appetizing. And despite a recent swoon, stocks could still be in store for a big disappointment if the economy fails to rebound sharply in the second half of the year, as many in the stock market still hope. Bonds, on the other hand, may already be priced for big disappointment.
No Certainty for Stocks
"We're really not even close to a point yet where we could state with confidence that equities will significantly outperform corporate bonds over the next six months," says John Lonski, managing director and economist at credit-rating agency Moody's.
But there are risks to wading into debt. If the economy roars back much more quickly than economists expect, bonds would still rally, but stocks might surge even more.
On the other hand, an economy that stays sluggish for a long time could spawn a growing wave of corporate bankruptcies that burn debt holders. What keeps policy makers awake at night is a worry that stimulus measures won't break the vicious cycle gripping the economy right now, in which tight credit hurts the economy, which hurts borrowers' ability to repay their debt and leads to still-tighter credit.
Even assuming some benefit from stimulus, Moody's expects high-yield-debt default rates to surge to 15% by the end of 2009, from just 4% at the end of 2008. That would be a record high for defaults in the modern era of junk bonds, which began in the 1980s.
Investment-grade default rates have been much lower, but will likely rise, as well. An economy that fails to respond to stimulus could push defaults still higher.
Meanwhile, some $758 billion in corporate debt is coming due in 2009, according to Standard & Poor's, meaning companies will have to either pay what they owe or refinance. Most of these debts were incurred five or 10 years ago, when rates were much lower, so refinancing will mean significantly higher borrowing costs for most companies. Less-creditworthy companies may not be able to get new financing at all. This increases the risk that companies won't be able to pay their debts.
In other words, very high yields on corporate bonds may be perfectly appropriate, given the risk that they could turn to dust in your hands. "It is still a very treacherous economic climate, and one has to proceed with caution" when buying debt, says Mr. Lonski.
Write to Mark Gongloff at mark.gongloff@wsj.com
