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Balloons and bonds

July 22, 2010

Rocky observes that when he pinches a balloon on one end, it expands on the other end.   This simple revelation has implications for his friends who continue to buy corporate bonds at ever lower yields, while ignoring the effects that it has on the stock prices of the same companies.

Bill Miller writes in his latest commentary, “US large capitalization stocks represent a once in a lifetime opportunity in my opinion to buy the best quality companies in the world at bargain prices.  The last time they were this cheap relative to bonds was 1951.  I was 1 year old then, but did not have then sufficient sentience or capital to invest.” 
See: http://www.leggmason.com/individualinvestors/documents/economic_perspectives/D9368-Bill_Miller_Commentary.pdf
Rocky doesn’t remember 1951, so he ran some tests on  Dow Jones Industrial Average stocks and bonds to test Mr. Miller’s hypothesis,  and found that the conclusions are impressive —  even if one makes the improbable assumption that there is ZERO real earnings growth over the next ten years.

(During the 2008/2009 financial crisis, corporate bonds were getting hammered too, so one could not have done this analysis in 2008. Also, so long as the  US population continues to grow, it’s extremely difficult to have zero economic growth, so this is a very conservative assumption.) 
Rocky’s choice : (1) Buy an equal-weighted basket of the 10-year debt of “quality” companies or (2) Buy an equal-weighted basket of the stocks of the same companies. Buy and hold for ten years.
Analysis of choice #1 (bonds):
The average return is 3.9%.  This is the  best case and assumes no defaults, leveraged buyouts, or other credit events.
Analysis of choice #2 (stocks):
The current average dividend yield is 2.9% per year on the stocks.
The current average earnings yield is 6.3%.
So if one  owns this stock basket and there is no earnings growth and no dividend growth, and the economy is Japanese-like, with intermittent recessions and growth, the return is 2.9% + 6.3% = 9.2% per year for the next ten years. (Which is remarkably close to the long-term average return for stocks.)  Here Rocky assumes no bankruptcies and assumes a terminal p/e which is unchanged. But it also ignores the possibility that the economy could do much much better (or much worse).
Some might quarrel that Rocky is double counting … when he includes the dividends. So he says, “ok, let’s forget about the dividends.”  Then, the stock basket’s earnings yield is 6.3% and the bond basket yield is still 3.9%, so it’s a pickup of 240 basis points per year for the risk/reward of owning stocks. Or, put another way, over a 10 year period, 10 x 2.4 = 24% … which means that the earnings yield could decline by more than 20% over the next decade and Rocky would still be better off in the stock market than in the bonds of the same companies.
None of this is making Rocky rush out to buy oodles of stocks tomorrow morning — because it’s certainly possible that stocks AND  bonds may decline over the next ten years. However,  for an investor in corporate bonds, this is an important result — particularly since in a SEVERE deflation or economic crisis, corporate bonds can get hurt badly. Note that Rocky did not include government bonds in this analysis — only corporate bonds.

Lastly,  if stocks keep declining and corporate bonds keep rising, the relative values will become more attractive, however, at some point, corporations will issue new debt and use their cash to repurchase shares … and that’s what will keep the relationship between corporate bonds and stocks in line.  Perhaps not at these relative valuations … but at some point.

Column1 = stock ticker
Column2 = dividend yield
Column3 = earnings yield. That is, earnings/price for the trailing 12 months.
Column4 = that company’s yield-to-maturity on its 10year corp bullet bond.
Column5 = earnings yield minus bond yield.
[There is a bit of fudging because Intel has no debt, so Rocky arbitrarily gave it a 3.2%. And he extrapolated some companies who had debt maturing in 8 years or 12 years.]
Data source: Bloomberg

  Dividend Earnings 10 Yr Corp Earnings YLD  
  Yield Yield Yield minus 10 Yr Bond Yld
AA UN Equity 1.1 -5.6 5.7 -11.3  
AXP UN Equity 1.7 3.7 4.5 -0.9  
BA UN Equity 2.7 3.5 3.3 0.2  
BAC UN Equity 0.3 2.5 5.8 -3.3  
CAT UN Equity 2.6 3.8 3.9 -0.1  
CSCO UW Equity 0.0 5.6 3.6 2.0  
CVX UN Equity 4.0 7.4 4.5 2.9  
DD UN Equity 4.5 6.0 3.6 2.4  
DIS UN Equity 1.1 6.7 3.2 3.5  
GE UN Equity 2.7 8.2 4.9 3.3  
HD UN Equity 3.4 5.9 3.2 2.7  
HPQ UN Equity 0.7 8.1 3.2 4.9  
IBM UN Equity 2.1 7.6 4.0 3.7  
INTC UW Equity 3.0 6.0 3.2 2.8  
JNJ UN Equity 3.8 7.2 3.7 3.5  
JPM UN Equity 0.5 6.5 5.1 1.4  
KFT UN Equity 4.0 7.5 4.3 3.2  
KO UN Equity 3.3 5.4 3.3 2.1  
MCD UN Equity 3.1 6.4 4.2 2.2  
MMM UN Equity 2.6 5.7 3.2 2.4  
MRK UN Equity 4.3 8.8 3.4 5.4  
MSFT UW Equity 2.1 7.3 3.0 4.3  
PFE UN Equity 5.0 11.1 3.1 8.0  
PG UN Equity 3.2 7.2 3.4 3.8  
T UN Equity 6.7 7.6 4.5 3.1  
TRV UN Equity 2.9 12.6 4.2 8.4  
UTX UN Equity 2.5 6.6 3.5 3.1  
VZ UN Equity 7.2 7.2 4.8 2.4  
WMT UN Equity 2.4 6.9 3.7 3.2  
XOM UN Equity 3.0 5.9 4.1 1.8  
Equal Wgt Avg 2.9 6.3 3.9 2.4


[Disclosure: Rocky is not recommending that anyone do anything that involves money or bonds or stocks or shoelaces. But he’s watching this relationship and has started to gradually move some of his “high quality” corporate bonds into the stocks of the same companies  — as the relationship becomes ever more attractive. He also notes that if you pinch a balloon TOO hard, it will burst. ]

  1. July 22, 2010 at 3:43 pm

    Trying to make sure I understand something you said. You say “SEVERE deflation” can hurt corporate bonds. The story I remember was something like fear of future inflation causes yields to go up? (As an investor I want more bang for my buck if my buck is worth less.) So it seems odd that you say that severe deflation can hurt corporate bonds. Is this because of higher default rates, or…

    Oh, and I think we should start calling it the “housing balloon.” When a bubble pops in the air, the left over soap and water is of minimal impact, but when a balloon pops you end up with this left over piece of plastic that litters the street and can choke seagulls to death. In addition no one ever is in shock when a bubble pops, but balloons can scare the hell out of innocent bystanders.

    • July 22, 2010 at 5:03 pm

      Dave: Severe deflation (and even modest deflation) can be a disaster for corporate bonds. Here’s an example:
      Company X issues $100 million in 5% bonds to build a widget factory. Their business plan is to sell 10,000 widgets per year at a price of $700 per widget. Their marginal cost of production is $100 per widget, which leaves them with enough cash flow to pay the $5,000,000 in interest payments and have some profit left over.

      Then deflation sets into the economy. And the price of widgets declines by 30%. Suddenly there’s no profit and not enough cash flow to cover the interest payments….and initially the stock price will decline more than the bond price, but eventually the bonds will default and end up in bankruptcy … and both the stocks and bonds will cause huge losses.

      Government debt doesn’t have this problem because they can always print money to make the interest payments.

  2. fatbear
    July 22, 2010 at 4:38 pm

    You make this look easy, but perhaps you’re too young – i.e., if one did a list like yours back in 1951, your stocks would include GM, Chrysler, Penn RR, NY Central RR, National Distillers, Johns Manville, American Smelting & Refining, US Steel, National Steel, Bethlehem Steel, Woolworths, National Cash Register, Sears Roebuck, International Harvester, and, last but not least, the Great Atlantic & Pacific Tea Company (in 1950, only GM had larger sales – and yeah, I know, not public till late ’50s). One could go on forever. And, of course, CSCO, HD, HPQ, INTC, MCD, MSFT, and WMT didn’t even exist.

  3. July 22, 2010 at 5:01 pm

    Fatbear: Thank you for your comment. Perhaps you spent too much time hanging around National Distillers? (Their only remaining prominent brand is “Old Grand-Dad” … hmmmm.)

    Picking the first four of your examples — GM, Chrysler, Penn RR and NY Central — all four of these companies went bankrupt. Put simply — you were crushed whether you owned the stock or the bonds. Right now most corporate bonds cited are trading around 110-130 (due to high coupons) which means if you recover 30 or 40 cents after a bankruptcy reorganization, you will have lost about 80% of your investment. In the stock you’ll lose 100% of your investment. In contrast, if any one of the 30 companies succeeds and doesn’t go bankrupt, you can double, triple, quadruple etc your investment — which will pay for the other losses. But there’s no upside in the bonds — i.e. the winners cannot make up for the losers. And if there’s either inflation or deflation, the bonds will get hurt from these valuations. Additionally, if there are leveraged takeovers of any of these companies, the bonds will get hurt AND the stocks will shoot higher.

    Importantly — if you are really a fat bear, you can buy Tbills and earn zero and and sleep comfortably at night. And if you think we are entering a deflation, you can buy government bonds and sleep comfortably at night. But please articulate a scenario where owning these company bonds is superior to owning the company’s stocks…

    • fatbear
      July 22, 2010 at 5:34 pm

      Well, my sister-in-law owned GM bonds (don’t ask me why), and she got 100% – can’t say the same for the shareholders. Does that qualify?

      Yet I knew the scion of an old Philadelphia family who kept his Penn RR bonds til the very end – but he was better known as a scholar. He had even kept his Philadelphia Traction Company bonds (PTC was later the bus company, Phila Transportation Co, eventually kaput and now part of SEPTA). Fortunately he had other assets and sources of income, and left much of his estate to charity.

      So I can see both sides. My point was that an evenly-split 1951 DJIA buy probably wouldn’t have done that well as buy-and-hold. But you’re right that the bonds would’ve been toast, too.

      One lesson is not to buy bonds over par; in general, I don’t. NYC GO munis are now issued over par, keeping the total debt down but raising the yrly interest cost on the par value. (Still going out with ~3% or higher coupon; offering prices on 5-7 yr can go 110-115, so you’re guaranteed a principal loss even while your broker-generated income statement looks good.)

      I would not buy a T-bill now if you paid me. There are many other gov’t guaranteed notes/bonds out there, short-to-medium date, paying better.

      And, you are absolutely correct, deflation will be a drag – but we better get used to it.

    • July 22, 2010 at 5:42 pm

      Fatbear: Please ask your sister-in-law which GM bonds she owned. Depending on the issue, the bonds were worth pennies to maybe 30 cents on the dollar. That was part of the Obama cram-down — where the employees’ pension fund was put ahead of the bond holders. Something doesn’t sound right there. Rocky is curious — and not an expert on the GM restructuring.

  4. July 22, 2010 at 5:06 pm

    Thanks Rocky! (I seem to remember something about stockholders be last in line for Chapter 7 bankruptcy, so does this mean that in most cases the bond owner ends up better off (or, uh less worse off) than the stock owner in the case of bankruptcy?)

    • July 22, 2010 at 5:15 pm

      Chapter 7’s (which is a corporate liquidation) are quite rare, and the proceeds are distributed from the top of the capital structure downwards. It’s rare that stock holders will get anything in a chapter 7.

      Much more common is a Chapter 11 restructuring — where the widget plant remains open and continues to make widgets — and the debt gets restructured. It’s not unusual for stock holders in a chapter 11 to get zilch, and it’s not unusual for stock holders to get some equity warrants. It’s also typical for the bond holders in all bankruptcies to take a haircut and get back much much much less than the amount they invested.

      Conclusion: The downside in both cases are huge. But in one case (the stock portfolio), the successes of one investment can offset the losses in a second investment. Whereas in the bond portfolio, the gains in one bond cannot offset the large bankruptcy losses from another. And given the current relative valuations, the corporates bonds look expensive compared withe stocks.

      What would be a good Quantum Theory example of this phenomenon in the physical world??

  5. July 22, 2010 at 5:38 pm

    Dave: One more thing: The phenomenon is especially pronounced in a low interest rate environment — where the overall yield on the bond portfolio cannot offset the potential losses from bankruptcy. It’s less pronounced in a high interest rate environment.

  6. July 22, 2010 at 5:55 pm

    Ha I wish I could say I knew how quantum theory would be useful here (One of the first internet discussion I can remember having was about how quantum theory could be used in finance…I was a skeptic, but in retrospect, maybe I was also young and naive 🙂 Maybe there is some magic juice from the quantum world that James Simons harvests at regular intervals.) I did check out http://www.amazon.com/Quantum-Finance-Integrals-Hamiltonians-Interest/dp/0521840457 once, but don’t remember it giving too much that I’d call intrinsically “quantum.”

  7. fatbear
    July 23, 2010 at 1:40 pm

    for some reason the “reply” thingie doesn’t show up on your last to me, so

    I only see her on holidays – next one is Thanksgiving – if I remember, will ask her – she told me that last Thanksgiving – she said it was a bond her late 2nd hubby had from the early 80s, back when men were men and rates were rates – it’s always possible it matured prior to BK, which I didn’t think to ask

    As for par, NYC GO just went out – no price, but 5% of 2016 is expected to yld 2.18% – so nearly 60% of the coupon is return of your own $ – my rough estimate of price would be 112-114 – perhaps you have the formula to calc – not a good deal in my humble opinion, but then again free advice is worth….

    • fatbear
      July 23, 2010 at 1:49 pm

      Oh, and there is one scenario where the bonds are better

      Certain mortgage-backed bonds, such as GMAC – in Fall 2008 they were under 50 – there was no chance that Fed would allow these to go under, and they didn’t – we as taxpayers are paying for that, but those with guts to buy are now sitting on cap gains plus the yld

      Same with some of the TIPS bonds, esp those due over next few yrs, some of which dipped under par on deflation fears and have now come back over par – can’t remember exactly when, but there was a small article in FT advising purchase at that time (also Fall 08) – I didn’t, as had some already, and have seen them come back nicely

  8. ld
    July 31, 2010 at 9:18 pm

    Maybe the retired/retiring baby boomers are not as willing to tilt their asset allocations toward stocks having experienced the recent years? Since Rocky does not recommend anyone do anything that involves money, I will continue doing nothing for now. It’s amazing how much time one can free up by applying this fantastic recommendation to other areas (can you tell I’m reading Walden). I don’t see an end to the line at the Apple store. All those people will need faster Internet and phone access with data plans (both of those paying nice dividends these days). I also don’t see the wars ending anytime soon, or the government spending way less money, or the Fed raising the rates to combat inflation, or Americans (or the rest of the world) walking and riding their bicycles instead of driving. Call me naive but when it comes to chicken stock, a little bit of nibbling with a lot of waiting makes for a decent soup for the soul – at least for now.

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