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 assymetric 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 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 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.
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 borrowers 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.