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
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 (
) 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
- 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
- On August 24, Norfolk Southern Railroad (
) 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
The Reflation Trade Is On