A 30-Year Bedrock Investment Assumption Is No Longer Valid: Instead of Bonds, Look Now for Dividends

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Cambrian Capitalist submits:

In the past month, we have observed historically low U.S. interest rates. On August 31, the 10-year US Treasury Note closed to yield 2.473%, and the 30-year US Treasury Bond closed to yield 3.522%. Outside of the credit crisis of two years ago, these are the lowest yields on Treasury bonds in nearly 50 years according to Federal Reserve data, which ends in 1962. Peak U.S. interest rates were observed on October 2, 1981. On that day, the 10-year US Treasury Note closed to yield 15.68%, and the 30-year US Treasury Bond closed to yield 15.07%. Fully two generations of investors have been conditioned to approach the financial markets in a way that presumes an environment of declining interest rates. That assumption is now erroneous. Everything investors knew about how to make money in the financial markets will have to be substantially altered in this new adverse interest rate environment.

Bond investors are typically a brooding, pessimistic lot--at least the good ones are. They are better off being like this, because at their most optimistic in approaching an investment in a new issue of bonds, the best they can do is clip the coupon (i.e. earn the stated rate of interest). In the current environment for 10-year corporate bonds, you are talking about 5%, for a high yield (i.e. junk) bond you are talking maybe 8%. Your down-side, particularly for junk bonds, can be severe in a bankruptcy or a liquidation or if a President of the United States wants to repudiate 200 years of bankruptcy law to repay his allies in the UAW by screwing over bondholders. Some bonds in a liquidation are paid out at less than 10 cents on the dollar, so the average bond buyer faces an asymmetric risk/return profile that is NOT in his favor.

While we have established some of the reasons why bond investors are downers, we need to establish why they are buying corporate bonds with such gusto in the past month and for increasingly puny yields. Here are just a few examples:

  • On August 12, Johnson & Johnson ( JNJ ) sold $1.1 billion of bonds at the lowest rates ever for 10-year and 30-year corporate debt securities. The 10-year issue was priced to yield 2.95%--only 0.43 percentage points higher than the equivalent Treasury, and the 30-year issue was priced to yield 4.5%--only 0.68 percentage points higher than the equivalent Treasury.
  • On August 3, [[IBM]] raised $1.5 billion in three-year notes, paying 0.30 percentage points more than the yield on comparable U.S. Treasurys. The interest rate, 1%, was a record low for three-year notes.
  • On August 24, Norfolk Southern Railroad ( NSC ) raised $250 million on a 100-year bond priced to yield 5.95% about 0.90 percentage points more than where the company's outstanding 30 year debt was trading. It was the lowest yield for 100-year debt bankers could recall, breaking through the 6% yield on the company's 100-year issue in 2005.

The reason for bond investors' uncharacteristic euphoria and desperation for yield is that they are being inundated with money to invest. The stock market, as measured by the S&P 500, has earned you about a 0% return over the last 12-year period while demonstrating uncommon volatility. Additionally, if you were one of the investors who purchased a 30-year Treasury in October 1981 and held it to maturity, you would have more than doubled the returns available to you in the historic bull market for stocks during that same time period, and would still have a year left to earn those returns--all while depending on the soundest credit in the world. So after getting the crap kicked out of them in stocks, investors have finally gotten some bond religion just in time for the great bond bull market to come to an end.

Nervous investors seeking to preserve their wealth and pick up yield have swarmed into fixed-income funds in the past two years. U.S. taxable bond funds saw estimated net inflows of $152 billion year-to-date through July 7, according to Lipper FMI. In 2009, the full-year total hit $384 billion. To put those figures into perspective, U.S. equity funds saw just $24 billion of inflows through July 7 and only $5 billion for all of last year.

Individual investors have had a historically bad time in stocks, but the current yields on bonds are never going to allow you to earn a return that will preserve your long-term purchasing power. So what is an investor to do? I believe the market is giving you a very big clue. Anyone who has tried to get a mortgage lately is having a pretty difficult time, as banks have returned to their conventional activity of assessing a borrower's credit risk. Consequently, those who are poor credit risks are not getting the loan. Although junk bonds (i.e. poor credit risk companies) have recently earned historically high returns, the spread between their yields and the equivalent Treasury yield (i.e. the credit spread) continues to be wider than its historical average. What this basically suggests is that access to credit is a significant competitive advantage for those companies that have it. Therefore, it is a good starting point to look toward investing in the stocks of those companies. In many cases, these same companies' stocks pay dividends whose yields are currently greater than the yield on 10-year and even 30-year Treasuries.

In conclusion, you should look to the credit markets for tips on what stocks to buy. The lower the yield on the debt they issue, the stronger their prospects for future profits for their equity holders.

Disclosure: No positions

See also The Reflation Trade Is On on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , US Markets

Referenced Stocks: IBM , JNJ , NSC , SPY

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