Tuesday, October 12, 2010

Bond in Drag

I am not a strategist or an oracle. But I know something smells funny when Johnson & Johnson’s (NYSE: JNJ) stock yields more than the bonds it recently issued to yield hungry investors. With U.S. Treasury yields in a free fall, investors looking to earn some sort of a return on their cash are willing to accept what appear to be insanely low coupons on corporate debt. The spread over risk-free rates may seem appropriate but the absolute yield is not enough to persuade us to forgo JNJ’s stock for its bonds.

Granted, the bond market may be signaling a faltering recovery with deflationary forces setting in and the stock market may get caught wrong footed. It is unlikely they can be both right. But we would rather collect a handsome dividend with potential for upside than earn a paltry return in bonds while locking up our capital for a lengthy period of time Even if the market does falter and JNJ’s stock declines, it is highly unlikely the company would cut its dividend. Plus, we would gladly hold the stock for the long run and buy more of it.

This is not meant to be a recommendation to buy JNJ’s stock but merely an illustration of the vagaries of Mr. Market. Investors of all types appear to be dumping equities in favor of the ‘safety’ of bonds and gold. What about all the money that is being printed by central banks all around the world? Could inflation be on its way sooner than people think one that money finds its way into the hands of borrowers? Higher rates would follow thereby decimating bondholders in its wake. Gold appears to be in agreement with this outcome as its price zooms ever higher if you agree with the characterization that it is a classic inflation hedge. The bond bulls on the other hand contend that the world is on the brink of collapse and we are in a deflationary spiral which will only lead to lower Treasury yields. Even if this is so, the bulk of the gains have probably already materialized and in any case the risk/reward profile just doesn’t seem to be there when compared with equities.

In any case, shouldn’t one be investing in equities when all others are reluctant to do so?! Apparently not if you ask David Rosenberg who is the high profile Economist and Strategist at the wealth management firm Gluskin Sheff in Toronto. In a recent note he thought it more prudent to lock one's capital up for 10 years in U.S. Treasuries collecting a paltry 2.4% yield (Mr. Rosenberg argues that bonds will mature at par reducing the risk of owning them. But what good is a bond which pays us 2.4% and locks up our capital with no optionality for 10 years!), described Pfizer (NYSE: PFE) as a “bond in drag” (Question for Mr. Rosenberg – wouldn’t your clients have benefited if you had actually bought shares of Pfizer when they were trading below $15? Why only point out the decline from $19 to $14 since the beginning of the year?), conjured up memories of Nortel (I am not kidding) when alluding to risk of owning equities and, finally, disagreed with Warren Buffett’s recent assessment of equity valuations:

“They’re making a mistake, the ones that are buying the bonds ... It’s quite clear that stocks are cheaper than bonds. I can’t imagine anybody having bonds in their portfolio when they can own equities, a diversified group of equities. But people do because they lack confidence. But that’s what makes for the attractive prices. If they had their confidence back, they wouldn’t be selling at these prices. And believe me, it will come back over time.”

The last time Mr. Buffett made such a proclamation was back in November 2008 when he wrote an Op-Ed piece for the New York Times and was ridiculed for his views. Well, we all know how the markets have performed since then.

Mr. Rosenberg and the bond/gold bulls could be right. We may end up with a double-dip recession and/or a decade of no growth à al Japan which would severely dent current equity valuations. To be fair, Mr. Rosenberg concedes that gold prices may have gone too far too fast. Still he conveniently touts the virtues of holding bonds in a deflationary world while at the same time advocating gold for its ability to preserve value as currencies get debased. But couldn't higher gold prices possibly be a prelude to dangerous inflationary forces eventually rearing their ugly head and destroying bond prices? Something doesn't add up here. To be sure highly successful investors such as John Paulson have also made huge bets on gold viewing it as a means of preserving their wealth (a currency substitute). But at least they don't deny the possibility of higher inflation/rates down the road.

As massive inflows into bond funds continue (Mr. Rosenberg rationalizes this by describing it as sensible asset allocation by oh so rational investors), the allure of owning rock solid businesses at today’s prices which offer attractive dividend yields is too much to pass on. At least we know Charlie Munger would rather own JNJ or Coca Cola (NYSE: KO) or Kraft (NYSE: KFT) rather than gold. Here is a classic quote from a recent speech by Charlie:

“I don't have the slightest interest in gold. I like understanding what works and what doesn't in human systems. To me that's not optional; that's a moral obligation. If you're capable of understanding the world, you have a moral obligation to become rational. And I don't see how you become rational hoarding gold. Even if it works, you're a jerk.”

No comments: