The Bond Market Has Lost It's Mind

The Wall Street Journal published this story regarding the recent high volume of bond issuance on Friday. 

The global corporate-bond boom is gathering steam as companies rush to take advantage of some of the lowest borrowing costs in history.

Companies from global giants McDonald's Corp. and Kimberly-Clark Corp. to Indonesian telecommunications company PT Indosat Tbk are rushing to sell debt.

This month has been the busiest July on record for sales by U.S. companies with junk-credit ratings. Asia's debt market is on pace for a record year, and European companies are also raising money apace.

The low borrowing costs are the culmination of an unprecedented bond-market rally that began in the depths of the credit crisis in late 2008 and early 2009 and has defied every prediction that it would soon run out of steam. But individual and professional investors continue to plow money into the bond market, giving companies a constant source of funds to tap.

With each new leg higher, the bond market gets more expensive and interest rates, which move in the opposite direction of price, fall even lower. If the economy heats up and rates rise, investors gobbling up bonds will get burned as bond prices fall. ...

Companies big and small are taking advantage of the low rates to bolster their balance sheets and lower their interest costs by millions of dollars for years to come. "I think we are accessing the market at precisely the right time, and a very opportune time," said Stephen De May, senior vice president for investor relations and treasurer of Duke Energy Corp., whose subsidiary in Indiana borrowed $500 million at 3.75% in early July, the fourth-lowest rate on record for a large U.S. corporate borrower, according to Bank of America Merrill Lynch.

McDonald's this week raised $450 million in 10-year debt at 3.5%, a record low yield for a large batch of debt issued by a U.S. corporate borrower. The U.S. government paid more than 3.5% for its 10-year debt as recently as May.

Now, if you have been paying attention, you will see that those yields are comparable to the dividend yields on the equities of those same companies.  The following is a comparison between dividend yields and yield-to-maturities of a select group of companies that have issued a significant amount of debt.  The bonds all expire in eight to twelve years.

The dividend yields of some of the highest quality companies in the world are comparable to or exceed the bond yields of the debt of those same companies.

Frankly, that's nuts.

There was a time when dividend yields consistently exceeded bond yields.  The thinking then was that since equities were riskier than debt, stocks should yield more than bonds.  But eventually, investors came to understand that stocks contain a growth element, unlike a bond, which is a contract to pay a fixed amount of interest and a return of principal at a given date.  For bonds, the total return if held to maturity is the yield.  At best, the bondholder can only be made whole.  However, for stocks, the owner of equity has, in theory, limitless profit potential.  Because profits grow, dividends grow, and the total return to stocks is the yield plus the rate of growth.  Thus, a little more than 50 years ago, the market began to price stocks at a lower dividend yield compared to bond yields for all but the most financially distressed firms.

If one looks at the table above, one could argue that the pharmaceutical and telecommunication companies face structural problems in their core businesses - pharmaceutical companies are not replacing products that are going off patent fast enough while fixed phone lines are in secular declines.  Thus, pharma and telecom companies will inevitably have to cut their dividends. 

But what about global multinational companies with fantastic brands, such as Coke, McDonald's and P&G?  These are some of the greatest companies in the world.  Why are their bonds yielding less?  Or regulated utilities?  I posted just a few utilities, but there are many utes with dividend yields that are comparable to or greater than the yield paid on their debt.  That's ridiculous, given that regulated utilities have targeted returns on equity embedded in the rate structures set by state utility boards, i.e. their profits are pretty much guaranteed.  For energy companies, stock prices have been hurt by the Gulf disaster, and yes, replacement of reserves is an issue, but it is bizarre to me that the securities further down the capital structure of some of the biggest energy companies on the planet yield more than up the capital structure.

In other words, the bond market has lost it's mind.

I am not one to say that stocks are table-pounding cheap here.  I think that certain stocks are attractive, particularly high-quality, big-cap multinational companies that are trading at 11x-12x earnings and sporting dividend yields of 3%-4%.  A basket of inexpensive, high-quality stocks is likely to earn an investor a return of 10%+ per annum over the next 10 to 20 years.  However, cheap stocks can get cheaper, and in the early 80s, similar high-quality big-cap stocks traded at 6x-8x, and paid dividends that yielded 6%-7%.

But I would rather buy stocks than bonds.

So what accounts for the bond market's current state of collective madness?  I can think of three reasons.

First is ZIRP, the Fed's zero interest rate policy.  Corporate bonds trade off the Treasury yield curve.  As the curve has shifted downward, corporate bonds have followed.  This is, at least in part, a rational response by investors to government policy.

Second is fears of deflation.  In deflation, profits fall and dividends are cut.  Of course, debt payments are fixed, increasing the financial strain on a company.  However, a little bit of deflation may have more of an affect on equity holders than bond holders, especially when companies are hoarding cash.

Finally, there is fear.  Retail investors were crushed during the Financial Crisis.  Many who sold at or near the bottom never bought back.  Having watched their savings cut in half, the Crisis has seared an indelible imprint on the psyche of the investment public, scaring investors out of stocks and into bonds.  This can be seen in the massive inflows into bond funds over the past 18 months and the continuing outflows from US equities.  Also, companies are holding record amounts of cash on their balance sheets, fearful of being cut out of the commercial paper and bond markets yet again.  This cash could be used to buyback stock, but that is not happening.

A rational investor would short the debt and buy the stock of the same companies.  However, given that this is an unprecedented time in American financial history, and the market is doing unprecedented things, one should greatly heed Keynes's saying that "the market can stay irrational longer than you can stay solvent."

However, in the long-run, rationality will win out, as it always does, and this will not end well for the owners of corporate bonds. 

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