Bonds or Stocks?
Oak Associates
Mark Oelschlager
August 19, 2010
This is a numbers business. It’s also a business of relatives. Relative performance, relative opportunities, etc. Leaving aside cash, there are two major asset classes that are both liquid and that investors use to build wealth: stocks and bonds. Bonds are considered safer, because debenture holders are in line ahead of stockholders. But the upside for a bondholder is limited, as payments are generally fixed. Equity holders participate in the upside when a company’s value is revised upward or when its dividend is increased.
So the relationship between bond prices and stock prices can be informative. And what is happening right now in the market is very interesting.
Since the market correction of 2008, investors have flocked to bonds and bond funds, and largely eschewed stocks and stock funds. The result is that bond yields continue to be driven lower and lower, and stock yields (dividend or earnings yields) higher. Over time, the relationship between these yields has of course fluctuated, but we seem to be at an extreme currently (with stock yields high relative to yields on bonds).
Earnings yield is simply profits for a given year divided by the market value of a company. Free cash flow can also be used, and that would be a free cash flow yield. So we can compare earnings yields with bond yields and compare the difference to what typically prevails.
Using high-yield bonds, which are issued by less-credit-worthy companies, the amount that the yields of bonds exceed that of stocks, or the spread, is currently close to zero. The modern high-yield bond market essentially began in the 1980s, and the spread has never been as narrow as it is now, indicating a strong preference for junk bonds over stocks currently.
If we use higher-quality corporate bonds the story is much the same. Bond yields are unusually low relative to stocks. Right now, stocks have an earnings yield of about 8%, while high-grade bonds yield about 4.5%.
Recent data points are almost hard to believe. Last week Johnson & Johnson issued 10-year debt at an unheard of 2.95%. If you buy these bonds and hold them to maturity, your return is capped at 2.95% annually. An alternative to this is to buy the company’s stock. JNJ’s free cash flow for the last four quarters is roughly $16 billion. The company is being valued in the market at $163 billion. This works out to a free cash flow yield of about 10%. If you bought the entire company, assumed the annual free cash flow stayed the same for ten years (a conservative assumption based on history), and took home all the free cash flow the company generated for those ten years, you would have earned 100% on your investment (or 10% annually), assuming the value of the company stayed the same (again, probably a conservative assumption).
Another way to look at the JNJ example is to focus on dividend yield. Today, the company pays to common shareholders a dividend equal to about 3.7% of its stock price. You can buy the bonds and realize a 2.95% return, or you can buy the stock and receive a 3.7% dividend – and any appreciation in the stock price. For perspective, JNJ has increased – not just maintained – its dividend for 48 consecutive years. The amount of the dividend has doubled over the last seven years, which means that if this happens again over the next seven years, the shareholder would be earning a 7.4% return on his original investment, without assuming any share price appreciation. Again, there is less risk with the bond, but the return premium that is priced into the stock appears excessive.
This is not intended as an extolment of JNJ stock. It is just an example of what is happening in today’s market. We could have used many different companies. International Business Machines, for example, a couple weeks ago issued three-year bonds at 1%. Investors gobbled up this debt, despite the paltry yield. Meanwhile, IBM stock is paying a dividend of 2%, and its free cash flow yield is 10%. One would have to conjure up a pretty dire scenario for the bonds of IBM – and for those of many other companies – to outperform the equity.
We haven’t even mentioned Treasury bonds, which currently offer returns of 2.6% for 10-year maturities. This is especially meager considering the worsening fiscal condition of the entity standing behind these bonds: the US government.
Earlier I alluded to the stampede by investors out of stocks and into bonds, and the aforementioned yields reflect that. According to investment research firm ISI, for the past three months, investors have pulled $177 billion out of stock funds and invested $262 billion into bond funds. This net difference of $439 billion has been exceeded only twice since 1990: near the bottom of the bear markets of 2002 and early 2009. In 1999/2000 equity fund flows exceeded bond fund flows by more than $600 billion, for a three-month period.
Issuance trends reflect these numbers. According to JP Morgan, equity is only 15-20% of the total mix (equity plus debt) of new funding right now for corporations, a very low level based on the last two decades. Management is reacting to the conditions in the market, taking advantage of low interest rates by issuing low-cost debt and in many cases buying back stock with its abundant free cash flow. Companies are in effect providing liquidity to the market, issuing the bonds for which investors are clamoring, and taking back the shares they are shunning.
The question that begs to be asked is why are investors showing such a strong affinity for bonds? The likely answer is rooted in recent performance and a preoccupation with safety. Bonds have outperformed stocks in recent times, and the two bear markets of the last decade are fresh in people’s minds. Shareholders lost a lot of wealth, and with those memories fresh, they are now seeking a more stable return on their money. Outside of dividends, the concept of a return on a stock is a bit amorphous, as a large portion of it is based on appreciation in the stock price, which can be driven by various factors. By contrast, a bond’s expected return is more certain and easier to quantify. People value certainty right now - mainly because we have been living through such volatile times. But because this certainty is so widely desired at present, the price of it has been driven up, as illustrated by the relative yields. It is interesting to contrast today’s environment with that of just over ten years ago. Back then, long-term Treasury bonds were yielding about 6.5%. This rate of return was nearly guaranteed and looks quite appetizing by today’s standards. Yet investors had little interest, preferring stocks, which carried an earnings yield of about 4%.
Historically, investors have been the perfect reverse barometer, as they have gravitated toward stocks/bonds at their peak and fled them at the bottom. Our belief is that this time is no different, and that it is wise to bet stocks will outperform bonds in the coming years. Of course there is no way to know when the current trend will reverse, but we are confident it will.
*Oak Associates has a position in Johnson & Johnson and International Business Machines
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