The Big Idea

Rotating from equity to debt

Steven Abrahams | July 28, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

For investors that hold both debt and equity, prospective returns across the sectors stand a lot closer today than they have for at least the last decade or more. The yield on the S&P 500 from expected earnings over the next year is only 5.33%, bringing it within a thin 133 bp of recent yields on the 10-year Treasury. Asset allocators now have to wrestle with potentially high but volatile returns in equities against much more competitive and likely less volatile returns in debt. Absent a clear reason for equity earnings to grow and fuel another leg of price returns, debt looks much better.

The convergence of cash flow benchmarks across debt and equity over the last few years comes more from a rise in debt yields than it does from a drop in equity yields. Yields on the 10-year Treasury have moved up more than 250 bp in the last two years while the consensus earnings yield on the S&P 500 is up less than 50 bp (Exhibit 1). This year, richening in equities has made the bigger contribution. Equity yield has dropped 62 bp while the 10-year Treasury yield has moved up a scant 12 bp. The yield gap between the S&P 500 and the 10-year Treasury is now at its narrowest point in a decade.

Exhibit 1: Converging yields between 10-year Treasury debt and equities

Note: Equity yield calculated as aggregated consensus analyst 1-year earnings projections for each company in the S&P 500 divided by S&P 500 price.
Source: Bloomberg, Santander US Capital Markets.

Comparing yields across debt and equity is an approximation, of course, but a useful one. Equity obviously promises a much longer stream of earnings than analysts’ 1-year projections, and equity valuation is leveraged to earnings growth. Those earnings also can either be retained or distributed to shareholders through dividends or share buybacks. Earnings are not exactly like debt coupons. But near-term earnings arguably are one of the more reliable parts of equity return, much as debt coupon is more reliable than price performance. Hence the comparison.

The tightening of equity yields to riskless debt leaves a healthy menu of risky debt with much higher yields than equity. Par 30-year agency MBS, 10-year ‘BBB’ and high yield corporate debt and all rated CLO debt currently has higher cash flow yield than the S&P 500 (Exhibit 2). If foreseeable cash flow is a starting place for expected return, then equity looks rich to a wide set of public debt, not to mention private debt that earns an additional illiquidity premium.

Exhibit 2: A wide range of debt has a higher current yield than equity

Note: All corporate yields based on 10-year maturities and Bloomberg BVAL yield curves, all CLO yields based on Palmer Square indices.
Source: Bloomberg, Santander US Capital Markets.

The other important consideration is the potential volatility of returns, and, equity, as it has in the past, is likely to continue to be more volatile than debt. Return series are not handy for all assets. But over the last decade, the annualized daily volatility of returns has run at twice the volatility of the most volatile debt, which is CLO ‘BB’ debt (Exhibit 3). The likely lower volatility of debt may still compensate for lower potential returns on debt.

Exhibit 3: Historical volatility of equity returns is at least twice the nearest debt

Note: Annualized standard deviation of daily returns from 7/29/13 to 7/27/23 based on the Palmer Square total return indices for CLOs, the Bloomberg indices for HY and IG and the S&P 500 index.
Source: Bloomberg, Santander US Capital Markets.

Investors have had plenty of experience with extreme events in markets in the last decade, so the maximum drawdown of assets can be just as important as traditional measures of risk—such as the standard deviation of returns—for evaluating assets. Equity shows a maximum 1-day drawdown over the last decade comparable to ‘BBB’ and ‘BB’ CLOs but materially greater than other major categories of fixed income (Exhibit 4).

Exhibit 4: Equity shows a maximum 1-day drawdown greater than most debt

Note: Maximum 1-day drawdown from 7/29/13 to 7/27/23 based on the Palmer Square total return indices for CLOs, the Bloomberg indices for HY and IG and the S&P 500 index.
Source: Bloomberg, Santander US Capital Markets.

The most likely institutional portfolio where this asset allocation plays out is at pension funds. The average large private corporate pension has ridden the equity rally of the last few years to become fully funded, according to the Milliman Pension Funding Index, making the opportunity to allocate out of equity and into debt more attractive. The average public pension is still underfunded, so the appeal of higher equity return and higher risk remains. Still, even for public pensions, large parts of fixed income may now yield enough to hit return benchmarks. This looks like a good time to rotate from equity to debt.

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The view in rates

OIS forward rates continue to put fed funds above 5.40% from September through December. The same forwards anticipate 125 bp of cuts in 2024, down from 140 a week ago. The stickiness of core inflation suggests cuts in 2024 look premature, especially cuts of 125 bp. The Fed looks more likely to hold fed funds at a terminal rate well into 2024, something that would actually tighten financial conditions if nominal rates stayed constant and core inflation dropped. Under those circumstances, real rates would rise. That is likely the Fed plan. The risk to the market is that sticky inflation keeps the Fed at higher rates for even longer, which would eventually create credit problems for balance sheets funded at floating rates that already are burning cash.

Other key rate levels:

• Fed RRP balances closed Friday at $1.73 trillion. Lately repo rates have run above the RRP rate of 5.30%, drawing away RRP cash.
• LIBOR officially went away on June 30, so goodbye, old friend. Setting on 3-month term SOFR traded Friday at 537 bp, up 2 bp over the last week.
• Further out the curve, the 2-year note closed Friday at 4.87%, up 3 bp in the last week. With the Fed likely to hike again and hold fed funds closer to 5.50% into next year, fair value on the 2-year note is above 5.00%. The 10-year note closed at 3.95%, up 12 bp in the last week. Much of the rise in 10-year yields came after hints of a shift in Japan’s yield curve control. With inflation likely to drift down and growth likely to slow, fundamental fair value on the 10-year note is closer to 3.50%.
• The Treasury yield curve closed Friday afternoon with 2s10s at -92, steeper 8 bp over the last week in the wake of concern about Japan’s yield curve control. Expect 2s10s to flatten beyond -100 bp again as the Fed keeps short rates high and concerns about growth and recession grip long rates. The 5s30s closed Friday at -17 bp, steeper by 2 bp over the last week.
• Breakeven 10-year inflation traded Friday at 239 bp, up by 4 bp over the last. The 10-year real rate finished the week at 156 bp, up by 7 bp in the last week.

The view in spreads

The Bloomberg investment grade cash corporate bond index OAS closed Friday at 140 bp, tighter by 6 bp in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 162 bp, tighter by 2 bp in the last week. Par 30-year MBS TOAS closed Thursday at 54 bp, wider by 1 bp in the last week. Both nominal and option-adjusted spreads on MBS have been particularly volatile in the last month.

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against the likely impact of Fed tightening. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. But other parts of the market funded with floating debt look vulnerable. Leveraged and middle market balance sheets are vulnerable, especially with the tightening of bank credit in the wake of SVB. Commercial office real estate looks weak along with its mortgage debt. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans in September should add to consumer credit pressure.