There are increasing signs that the run in high-yield bonds is reaching levels that are unsustainable relative to other asset classes.
Late last year, something that has not happened in two decades took place, and it is not a good omen for high yield bond markets.
The yield on the benchmark Merrill Lynch high-yield bond index dropped below the earnings yield on the Standard & Poor's 500 Index (that is, the inverse of the price-to-earnings ratio).
Until 2000, when equities were in favour and bonds were for losers, the earnings yield was lower than the yield on pretty much any other major asset class. In order of size from smallest to largest, it went S&P earnings yield, then Treasuries, then investment grade corporate bonds (represented by BBB credits) and then high-yield bonds. It was that way for all of the 1990s.
Starting in 2000, the equity earnings yield started to climb, first passing Treasury yields in about 2001, then surpassing BBB corporates in about 2009, and finally topping high yield in recent months.
With such moves in valuation, bonds are the most overbought in 55 years, according to Loomis Sayles bond fund manager Dan Fuss. (He said it in an interview with Bloomberg, which you can read here . And you should, because as Bloomberg notes, Mr. Fuss's fund has beaten 98 per cent of its peers in the past three years.
As far as high yield, Mr. Fuss told Bloomberg News that it "is as overbought as I have ever seen it," adding that "This is absolutely, from a valuation point, ridiculous."
Similarly, in his most recent commentary, Toronto-based bond fund manager Barry Allan of Marret Asset Management observed that high yield "is fully valued given low absolute yields with the exception of resource credits." In his view, valuation is not the only issue.
"Technicals favour equities over high yield as fund flows have already been much stronger into high yield. High yield is unlikely to be negative in 2013 if equities have another good year, but equities are likely to outperform even risk adjusted."
Despite the valuation issues, in their hunt for yield, investors are not showing any signs of seriously slowing flows into high-yield funds.
Caveat emptor.
(Boyd Erman is a Globe and Mail Capital Markets Reporter & Streetwise Columnist.)
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