(Bloomberg) -- In a role reversal, stock investors are the market’s pessimists-in-residence while their peers in credit are flocking to Corporate America’s riskiest securities.
Equity investors have got the memo.
S&P 500 stocks teeming with risky debt have fallen 2.6 percent this year, compared with a 0.2 percent decline for companies with the healthiest financial ratios, according to baskets compiled by Goldman Sachs Group Inc.
Credit investors, by contrast, remain bullish as the hunt for yield continues. CCC rated bonds have returned 1.2 percent this year, as high-yield premiums over Treasuries returned to post-crisis lows. The investment-grade gauge is down 3.4 percent.
"The equity market is less ebullient now than the credit market," UBS Group AG strategists including Bhanu Baweja wrote in a recent note.
The driver is a climate of rising interest rates and economic expansion that has credit investors snapping up shorter-duration bonds -- benefiting lower-rated companies in the process.
However, there are technical drivers behind the outperformance of junk debt, from renewed retail buying and higher oil prices to a modest net supply while foreign investors are paring their investment-grade holdings amid rising hedging costs. But the bullish business cycle and demand for obligations that cushion against rate increases account for much of the rally, according to strategists.
"What is contributing to investor comfort in the high-yield space is the lack of catalysts for defaults for the next one or two years," said Anindya Basu, head of U.S. credit derivatives strategy at Citigroup Inc. "In a rising rate environment, the shorter duration of CCC rated debt has contributed to its outperformance, while investors hedging tail risk are focusing more on rate risk and a policy error by the Fed."
By contrast, weak balance sheet stocks are heading for a fourth-consecutive month of underperformance as warnings from world finance ministers and central bankers mount over the global debt burden.
View From Vol
Still, there’s one bright note for equity bulls: The volatility landscape shows a more sanguine attitude toward highly-indebted companies, suggesting stocks may ultimately catch up with credit.
The one-month historic volatility for weak balance sheet stocks is 5.7 percentage points lower than that of their cash-rich counterparts, the biggest spread since 2007. Put another way, there’s a relatively high level of confidence in their prices, and thus future cash flows.
That perceived reliability has been one of the "main drivers of credit” outperformance, according to Andrew Lapthorne, the global head of quantitative strategy at Societe Generale SA.
"The low vol captures the fact that investors think things likely won’t get worse" for weak-balance sheet companies, said Stephen Caprio, credit strategist at UBS.
One reason why weak balance-sheet stocks have been less volatile relative to their stronger peers has been the roller coaster in tech shares. Looking under the hood of strategies in the quant world reinforce the notion that stock investors are wary of leverage.
After controlling for other factors like size and industry, a concentrated bet on the most indebted companies has been flailing of late. The Bloomberg U.S. Pure Leverage portfolio has posted five consecutive quarters of declines, the longest losing streak since 2009, data compiled by Bloomberg show.
And while the market is currently hospitable to junk notes, the paring of monetary stimulus remains an ever-present threat to global credit.
"As central banks shrink their balance sheets, we are likely to see a transitional phase where volatility shifts to a temporarily higher regime as markets adjust to the new environment," Basu at Citigroup concluded.
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