Gridley Associates Inc

SEPTEMBER NEWSLETTER

Time to Sell Your Bonds?

Bonds, and by extension bond mutual funds, have posted remarkably strong returns in the past two years. Unfortunately bonds, unlike stocks, have a finite upside potential. The reason for this is simple. Over their life bonds pay you interest and a fixed sum of principal at maturity, but no more (and hopefully no less.) In simple terms as the price you pay for a bond approaches the sum of all those cash flows your return drops to zero. Unless you can convince an exceptionally stupid investor to pay you more in cash than the bond will ever produce, the upside is "maxed out" when the total return equals zero. Why is this important? Because bond yields are now approaching their "max" and will at best pay a low current return and at worst produce substantial potential short term market losses. Put another way, the risk/reward ratio in owning bonds is currently skewed more toward risk than reward.

As I see it the bond market, especially US Treasuries, are now in a bubble. While it may not burst for a while, someday, perhaps soon, it very likely will. Trouble can come from either of two directions, either because interest rates begin to move higher, or more likely, because bond investors begin to think interest rates will move higher and start selling all their bond holdings. This problem likely won’t be isolated to treasuries, all bonds are at risk, but treasuries and high grade corporate bonds are especially ripe for a fall. Big corporations are hurriedly issuing new bonds at record low yields so as to take advantage of low rates while they can. Want some examples? IBM recently issued a 3 year Note at a 1% yield, 1%! Johnson and Johnson issued a 10 year note at 2.95% and even Home Dept, which is not the greatest credit in the world, was able to sell 10 year notes at 3.95%. For an individual investor in a high tax bracket your after tax yield is only about half this, and of course mutual funds will take management fees out as well, so there just isn’t much of any real yield here. Oh and let’s not forget about inflation which over the last ten years has run at about 2.5%. Quite simply we have arrived at the point of near 0% net returns which is very likely to correct, and may do so in an unpleasant way.

So what do you do? One solution is to consider selling some of your bonds and buying stocks that offer decent dividends instead. Not only do current dividend yields on some companies’ stocks exceed the yields on their bonds, but they’re taxed at a more favorable rate than bonds as well (and likely will continue to be.) Also, as the economy recovers stocks have the potential to appreciate in value which could further enhance your return, and again in a potentially tax friendly way. Sure there is risk involved in owning stocks but I’d argue that there is also considerable market risk today in holding high quality bonds. Against 1% on IBM’s 3 year note, I think IBM’s 1.8% dividend looks pretty good. Similarly so does JNJ’s 3.1% dividend versus the 2.95% yield on their new 10 year note. I may be taking some risks but at least with their stock I have some real upside potential in an economy that is likely to gradually improve over the next several years. Clearly this bond for stock trade is not for everybody and you should carefully consider your risk tolerance before moving in this direction; but at a minimum consider the risk you also face in your high quality bond portfolio or bond fund as they may harbor at least as much market risk as high quality stocks. Remember that bonds are not always a safe investment.

 

Randy Gridley

September, 2010