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Scared of Stocks? Dip Into Corporate Bonds

Scared of the stock market? It could be a good time to dip into corporate bonds.

More than a few economists and strategists have pointed that out in the last couple of days, as spreads widen to record levels. Today, Citigroup's Steven Wieting says in a note that the cost of corporate credit, and therefore investor returns, have probably eclipsed long-term stock market returns on a risk-adjusted basis.

"In our view, corporate debt markets that looked very rich relative to equities in early 2007 have "blown right past" equities in their recent declines, on a risk-adjusted basis," he writes.

Also today, Michael Darda, chief economist at MKM Partners, made a tactical call to go long investment and high-yield credit.

"While we remain very negative on the growth outlook, we believe it has been fully priced into corporate credit markets," he wrote. Darda also points out that investment grade bonds are yielding more than 500 basis points over Treasurys, the most since 1933, while high-yield spreads are 1421 bps over Treasurys, the highest level ever.

Bank of America's Jeffrey Rosenberg moved to overweight high-yield last week. Investors should beware that high-yield instruments command a high yield because they are the riskiest, lower quality credits.

Wieting writes that he doesn't think the stock market has necessarily bottomed. He said credit markets have become too cheap and could ultimately return to more normal conditions. If that's the case then stocks would benefit, but not as much as credit. Actions by the policy makers to break the credit crunch improved the case for that scenario.

Darda says he does not expect spreads, or the economy, to return to normal soon, but even so there could be significant gains for investment grade and high yield credits if the recent improvement in the short-term funding markets holds.

"We are assuming forward earnings estimates for the S&P 500 are about 25 percent too high, but the current level of equity prices appears to have taken this into account (based on a stringent earnings yield/corporate bond yield comparison). However, we will need to see the corporate bond market improve for stocks to move higher on a sustained basis. If our call on investment grade and high-yield credit works out, the backdrop for equities would improve," Darda wrote.

Darda also notes that because he does not believe credit spreads will return to normal any time soon, the upside in risk assets may be limited. But he says the opportunities in credit are probably better than equities for now. "Stocks typically bottom 3-6 months before the economy and we see no prospects for an economic recovery until the second half of 2009 at the earliest," he wrote.

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