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.
Toro, I am missing something.
You've got all your facts correct but, for my 1st time, I cannot support your conclusions.
Starting with your:
"Frankly, that's nuts."
&
"The thinking then was that since equities were riskier than debt, stocks should yield more than bonds."
I found GE & PFE's dividend cuts justify such a valuation.
Generally, dividends are at much greater risk than the interest payments on the senior security.
Please try "stocks contain a growth element [until they don't]" because I don't think MCD, T, INTC, PFE, GE, etc. contain much of a growth element now.
We are in an environment of sincere and intense deleveraging, reinforcing a disinflation so strong that, for 1st time im my lifetime, actual deflation is a nonzero probability.
(Qualification: Greenspan's worries about deflation following the dot.com bust always struck me as a disingenuous excuse to pump up the money supply for the benefit of the banks).
Current profit growth is from layoffs, not technological advances or organic growth.
Our GDP is still less than its peak before the recession started.
Your "a little more than 50 years ago, the market began to price stocks at a lower dividend yield compared to bond yields"
is perfectly correct, but we had real growth between 6% and 10% under our belts when that trend started, with a bright future ahead of us.
Now we've got minimum 4 to 6 more years of contraction, consolidation (especially in banks), deleveraging and a buncha government debt to pay off with declining tax revenues.
Re: "in the early 80s, similar high-quality big-cap stocks traded at 6x-8x, and paid dividends that yielded 6%-7%"
I think it more helpful to remember the context, viz. double-digit inflation and low profit growth justified discounting to such low multiples.
Disclosure: Have already started buying MSFT, XOM, hope to add to JNJ position, another flash-crash and I'd love to back up the truck on PG around $48/sh.
Conclusion: What you find "nuts" I find to be mildly, but only mildly, comforting. We're getting outta La-La land.
Posted by: psychodave | August 02, 2010 at 10:04 AM
don't forget the $35135413213512M dollars that has rushed into anything high yield in the last year. That capital has to be put to work somewhere and most of those funds have relatively narrow mandates.
Posted by: shaun noll, CFA | August 04, 2010 at 06:41 PM
Dave
Sorry to take so long responding.
If you own stocks during deflation, the stocks you want to own are the stocks of the highest quality companies in the world. Those companies are multinational consumer companies with a moat around their businesses.
I would agree with you that the pharmas and the telecoms are businesses with moats that are being filled in. However, I would disagree with you on the likes of MCD and INTC not being growth companies anymore. They aren't high growth companies, but they are companies that will have higher revenues 10 years from now, in my opinion.
I deliberately did not include any financials, and GE is at least, in part, a financial. However, it's industrial business will benefit and will grow if you believe in the continued growth of the emerging markets.
And, in all due respect to the retail investor, the retail investor has been stampeding into bonds. I can't think of a time in my investment life, nor can I recall a time in history when the retail investor was spectacularly right. The retail investor is often spectacularly wrong - i.e. tech bubble, housing bubble. Betting on bonds here is betting that the retail investor will be spectacularly right. That's not a bet I'm willing to make.
On deflation, the forces in the economy are very deflationary. However, the responses are very inflationary. Over the past several months, the responses of governments have been less inflationary, and the political environment in America is currently tending towards deflation. But ultimately, I don't believe that the government nor the central bank of the United States will allow deflation to occur in any meaningful way.
T.
Posted by: Toro | August 07, 2010 at 12:37 PM
"Betting on bonds here is betting that the retail investor will be spectacularly right. That's not a bet I'm willing to make."
No question. I've begun my rebalancing from 75% bonds & 25% stocks to 50/50.
Thank you for your response. I was reacting emotionally because I like very much a situation where i could buy XOM when its dividend yield is more than the 10-year Tsy's. I wish things could stay like this forever.
I took your calling it "nuts" as:
a) confirmation of my recent purchases (Yay!)
b) a call for change (Boo!)
Re: "in all due respect to the retail investor"
If you had any respect at all for the retail investor (viz. moi!) you wouldn't have even mentioned MCD. A personal anecdotal investing blunder big enough to make it statistically significant, resulting in conversion of your mild prejudice against retail investor allocations into a firm Law of Finance and Capital Allocation.
I concur 100% with everything else in your response. My bringing GE into the discussion was (ahem, blushes) rhetorical flourish. Guess i'll just have to keep looking in [on your excellent blog -db].
Best,
Dave
Posted by: psychodave | August 09, 2010 at 08:38 AM
Toro - I am confused by the apparent contradiction between your view of asset valuations and your actual asset allocation. You say that the 11-12 PE blue chip multinational steady growers should return 10%+ over the long-run, yet you are 80% in cash.
Could you explain why you are passing up a group of assets with expected 10%+ annual returns, in order to stay parked in something with a 0% return?
Also, you say that what is cheap can get cheaper. Yet that is true at all times in all markets, it was true even at the 1932 lows.
Posted by: Mark L | August 11, 2010 at 04:04 PM
Mark
I try to make higher returns than 10%. Plus, I think these stocks are dead money for the next few years, even at these attractive valuations. I'd rather put my capital to work and earn a higher return. I think it is a traders market, and it has to be bought and sold.
T.
Posted by: Toro | August 17, 2010 at 09:09 PM