Bonds beat stocks

From the end of October (when yields on corporate bonds peaked) through yesterday, an investment in investment grade corporate bonds did far better than an investment in stocks: 10.1% vs. -8.2%. This is due to the relatively high yields on bonds coupled with a decline in the yield to maturity of bonds over that period.

Several things are driving this recovery, which comes after a long period of dismal performance for corporate bonds. More aggressive easing on the part of the Fed is reducing deflation risk, and that in turn reduces default risk, which is ultimately the nemesis of any corporate bond investor. At an extreme, inflationary monetary policy reduces default risk by making the burden of debt disappear, allowing borrowers to repay debt with dollars that are very easy to acquire. But another important factor is that the very high yields and yield spreads that we saw recently can only persist if the economic outlook continues to deteriorate, thus pushing default expectations higher. I think the market was priced to a catastrophic scenario, and the news has just not been that bad. As a result, the market is now pricing in a less-terrible scenario, and that means that default expectations are falling.

The best explanation for why bonds are outperforming stocks of late is that these two factors—easy money and an economic outlook that is "less worse" than expected—make debt look more attractive by reducing default expectations but fail to convince equity investors that the outlook for profits will improve.