Our inspiration for this piece is a Wall Street Journal article, entitled “Stocks for Income, Bonds for Speculation,” published last Thursday. It seems upside down, backwards, or perhaps wrong, but this is the state of most world stock and bond markets as we write this.
Bond yields have been on the decline worldwide. Last week the yield on a 30-year U.S. Treasury bond fell below 2% for the first time in U.S. history. But wait! There’s more! 30-year German and Swiss government bonds have negative yields! In effect, those governments are being paid to borrow money.
Locking in 2%/yr returns for 30 years is an imprudent use of investment capital. Buying-and- holding negative-yielding bonds is simply ludicrous. Clearly, speculators are active, betting on future economic weakness and, with it, even lower interest rates. But more negative?! Yes. The global supply of negative-yielding debt has risen to US$16 trillion. And if they’re wrong?
Eventually, the direction of interest rates will reverse course. Interest rate trends are typically long in duration. The current downward trend began in 1981. In 1981, yields on 30-year US Treasury bonds topped out at over 14%. Ask any Baby Boomer what it was like paying double- digit interest rates on home mortgages back in the early ‘80s. (As an aside, if you have an adjustable-rate mortgage or 4.5%-or-higher, fixed-rate mortgage you should speak to a mortgage specialist – and don’t wait – about refinancing opportunities.)
We can calculate the interest-rate risk to the buy-and-hold bond investor. Duration, expressed in years, is the time-weighted average of the bond’s cash flows and is a measure of a bond’s price sensitivity to changes in interest rates. Hypothetically, let’s say a bond investor buys a 2% coupon, 30-year US Treasury bond at par. The duration of this bond is approximately 23. This implies that for every 1% move higher in interest rates this bond would fall 23% in price. Should rates on the 30-year bond double to 4% – something we view as highly probable given that they were at 3.375% just last November – this bond would theoretically decline 46% in price! (The actual decline would be less because of the asymmetrical relationship between
large changes in interest rates and bond prices.) If the bondholder has the intestinal fortitude to hang on until maturity in 2049 there is no loss. But does she?
For income investors who can tolerate credit risk there are many types of fixed-income investments besides government bonds to choose from. However, yields on non-government bonds have sharply declined as well. The low-interest-rate environment has pushed many traditional fixed-income investors into so-called “bond proxies,” such as preferred stock, REITs, MLPs, and common stocks of utility companies. These are not bonds, which are promises to pay, but they do offer higher yields.
The dividend yield of the S&P 500 index is currently 1.9%. You can earn as much, if not more, income on US stocks, broadly speaking, than you can in US government bonds of various maturities. This is not the norm. Going back to 1958, high-quality US bonds have yielded more than US stocks and, most of the time, by a wide margin.
We can evaluate the relationship between bonds and stocks by dividing the yield of a long-term government bond by the earnings yield (1/Price-to-Earnings Ratio) of the stock market. At current levels, the formula implies that stocks are very cheap relative to bonds. Currently, investing in a portfolio of dividend-paying, “blue-chip” common stocks can provide greater absolute income than high-quality bonds with the added benefit of long-term price appreciation.
Though not a recommendation, we have listed below for illustrative purposes a sampling of stalwart common stock names with attractive yields:
Exxon Mobil 5.01%
It’s a mad, mad, mad, mad world. Invest accordingly.
Jack E. Ditt, Jr. William L. McCollum