"Bonds - Certainty in an Uncertain World"

Sydney M. Williams

Thought of the Day

“Bonds – Certainty in an Uncertain World”

August 13, 2010

Even in times of uncertainty, excesses build. I am not suggesting that we are witnessing the rising of a new bubble, but intemperance seems to be forming in the bond market. While I am far from an expert, it seems to me that that market is displaying such signs. The prospect of deflation has sent investors scurrying to bonds, especially Treasuries. The yield on the Two-Year Note is 49 basis points and on the Five-Year it is 1.42% – not much of a return, even with the most recent CPI numbers of 1.1%. Perhaps more surprising is that more than half the Dow Jones stocks yield more than the Ten-Year Bond.

An unusual, and likely not sustainable, aspect of the current environment is that while the Fed’s balance sheet, since 2008, has risen from $1 trillion to $2.4 trillion, interest rates have fallen. Economics 101 teaches that when the demand for something increases the price goes up, not down. The decline in rates can be attributed to fear – thus chasing safety – and to concerns that we are in the early stage of a bout with deflation. There are many who fear that the upcoming decade may be to the U.S. what the 1990s were to Japan – a lost decade of little to no growth, accompanied by rising debt and declining interest rates.

The analogy, to me, is a little too cute and convenient. While I don’t dispute that, despite expected growth from the emerging world, growth at home is likely to be sub-par, the differences between Japan and the U.S. are too large to ignore. We have abundant raw materials. Japan has very few. In terms of population, we are two and a half times larger than Japan within a landmass 24 times bigger. Japan’s population is aging faster than any other country in the world and began declining in 2005. While our population is aging, it is not aging with the rapidity of Japan and, more importantly, it continues to grow. Our currency (at least, for now) remains the world’s reserve currency. The speculative bubble Japan experienced in the late 1980s, both in stocks and real estate, far exceeded anything we exhibited in 2000 and 2005. I don’t view lightly our problems, but I disagree with the comparison.

Enthusiasm for bonds is not limited to Treasuries. Both Investment Grade and High Yield bonds have performed well this year, so that four Dow Jones stocks – AT&T, Merck, Pfizer and Verizon – now yield more than the FINRA-Bloomberg Corporate Bond Index. Year to date, the yield on Investment Grade bonds has declined from 5.07% to 4.42%, while that on High Yield has fallen from 9.57% to 8.37%. In contrast, the S&P 500 is 2.6% lower than it was at year end.

According to the Securities Industry and Financial Markets Association (SIMA), corporate bond issuance in the U.S. this year has been $437 billion, down 7% from a year earlier. However, of that, $148 billion has been issued in High Yield bonds, up 77% from 2009, according to yesterday’s Wall Street Journal. It suggests that, while a desire for safety has driven Treasuries higher, a quest for risk within bonds has driven investors into the speculative arena of Corporates. In contrast global equity issuance, at $309 billion, is at its lowest level since 2005.

In the past couple of weeks, Kimberly Clark issued 10-year bonds at 3.62%, which compares to the 4.1% yield on their common stock. Last week IBM sold $1.5 billion three year notes at 1%, a record low, both in absolute terms and relative to the comparable Treasury Note. The yield on their common is 2%. While we do not follow, so have no opinion on the following companies, it is of interest to note that the dividend yields on AT&T, Verizon, Bristol Myers, Eli Lilly, Merck and Pfizer exceed that of the coupon yield on their bonds.

Historically stocks used to yield more than bonds, as stocks, lower in the corporate structure, were deemed riskier. But following the creation of the SEC, improved reporting standards, a return of some inflation and, as memories of the speculation of the 1920s began to fade, stocks began attracting investors, drawn to the potential of rising dividends. Over the next few decades, until early 2000, dividend yields declined, as stock values increased more rapidly than dividend growth.

Similar to stocks, there have been long cycles in bond yields. A chart of the Ten-Year, back to its inception in the early 1960s, shows what appears to be the view of a steep mountain – climbing from 4% in 1962 to 14% in the early 1980s to 2.68% today. Will this trend reverse? Certainly. When? I have no idea. But the “certainty” manifested in the meager return of “safe” assets should raise eyebrows. If deflation is not to be our future, watch out.