The stock-bond disconnect

By Felix Salmon
September 21, 2010

I’ve been pondering the disconnect between stock and bond prices of late. It reminds me a bit of late 2007, only the other way around: back then there was a credit crunch, but the stock market continued to hit new highs. Today, stocks are largely sitting out the bond bubble.

Exhibit A in these matters always seems to be Johnson & Johnson, which has a dividend yield significantly higher than its 10-year bond yield of about 3%. Whitney Tilson went on TV yesterday and put the thesis in its starkest terms:

We don’t understand what any long-term investor could possibly be thinking when Johnson & Johnson, a month ago, issued all-time record low 10-year corporate debt at 2.95% and the stock yielding 3.8%.

Clearly the two markets are telling you that what investors rationally might be thinking is that we’re in for ten years of Japanese-style deflationary horrific environment, and I think the odds of that are less than 5%. I think it is 95% likely, for example, in the case of Johnson & Johnson, that if you’re going to own something for ten years, you will do massively better owning the stock, both from the appreciation of the stock and the dividend yield you get over those 10 years, than a mere 2.95% owning that 10-year bond they just issued.

There are two problems with this argument, as I see it. The first is that we’re not faced with a simple binary outcome, where either we have Japanese-style deflation, or else the stock will outperform the debt. It’s entirely possible — there’s a nonzero possibility — that J&J stock will fall over the next ten years, rather than rise: that Whitney’s stock appreciation will be negative rather than positive.

J&J is an extremely creditworthy company, and you can be pretty sure that if you paid $62 for that bond at a 2.95% yield, then over the next ten years the company will pay you a total of $80.29 in nominal dollars. (You’ll see why I chose $62 in a minute.)

Meanwhile, the cashflow associated with buying $62 of J&J stock is much less certain. You might well get a 3.8% dividend next year — that’s $2.36 — but you don’t know what you’ll make in subsequent years. Let’s assume the dividend stays constant at its current level: then over ten years, you’ll get $23.56 in dividend payments.

In order for the stock to outperform the bond, then, it has to be worth more than $56.73 in ten years’ time. (I chose $62 because that’s the price that the stock is trading at today.) That’s hardly unthinkable: in fact, it’s pretty much where the stock was trading just three weeks ago.

Of course, you can tweak your assumptions. You can start reinvesting dividends — but then you’d need to make assumptions about reinvesting the bond coupons, too. You can say that some kind of dividend growth is likely — but then you’d also need to price in the probability of the dividend being cut. And so on and so forth. What’s more, there’s something safe and attractive about just getting $80.29 in cash, compared to getting $23.56 in cash and a stock certificate which you could theoretically sell for something over $56.73.

More generally, if you buy J&J stock, you’re making a bet on the future prospects of a particular U.S.-based consumer-goods company. Those prospects might be good, but there’s still a lot of idiosyncratic risk there. The bonds, meanwhile, are almost certain to be paid back in full whatever happens to the company. (Unless of course J&J takes Tilson’s advice and runs with it, levering up enormously in order to buy back its stock. But it seems unlikely it’ll do that.)

It’s entirely rational for investors to be risk-averse, and to prefer a certain $80.29 over ten years to a very uncertain future direction for J&J’s stock price and dividends. After all, J&J stock could perform wonderfully well for the next nine years, increasing its dividend and generally being very healthy, only to suddenly plunge in 2020. Stranger things have happened, in this volatile market.

What’s more, Tilson’s numbers aren’t the only numbers you could use to perform this calculation. J&J’s average bond yield, for instance, is 3.2%, and some of its debt yields as much as 4.6%. Meanwhile, Reuters’s numbers put its dividend yield at 3.48%, rather than 3.8%. And in any case J&J is something of a special case, because its bonds are so very safe. It’s up there in the top four companies in terms of the difference between their dividend yield and their bond yield: the other three are Exxon Mobil, Nestle, and Procter & Gamble.

All that said, I do suspect that a long-term investor putting money into stocks right now is making a more sensible bet than someone putting the same money into low-yielding bonds. Stocks have unlimited upside, and tend to keep pace with inflation over the long term: they’re real assets, not nominal assets. And bonds have a lot of downside, as a quick look at the extent of the recent bond rally will demonstrate.

It’s impossible to invest these days without taking risk; I just feel that the risks in the stock market are more known and more priced in than the risks in the bond market. Interest rates will surely rise at some point. And when they do, you don’t want to be invested in bonds. Buy-and-hold investors, pretty much by definition, don’t have a strategy for selling the bonds that they’re buying right now. But are they prepared for possible future price declines? I don’t think so.

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