Felix Salmon

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.

19 comments so far | RSS Comments RSS

A terrific post, re both you and Tilson. Tilson is a superstar and he is likely to be with us for many decades to come. He has very high integrity, and (a rarity!) he sincerely wants to help the small investor, having been a leading contributor at Motley Fool for years.

He will be a great signpost for us in the coming years.

Posted by DanHess | Report as abusive

“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.”

Very well put. There are risks to any investment. While stocks are conventionally considered riskier than bonds (and are certainly more volatile), that is very different from asserting that bonds have “no risk”. And right now, bond yields only make sense if they truly carry no risk. No risk of inflation, no risk of default.

That said, I wish we were living in less uncertain times. Asserting that bonds are effectively almost as risky as stocks is a condemnation of the bond market more than anything else.

Finally, keep in mind that the multinationals are, well, MULTINATIONAL. I believe (hope?) that the global economy will show greater growth than the US/Europe/Japan economies over the next decade. That growth, if it materializes, may help to forestall actual deflation in the developed nations while supporting modest earnings growth for multinational corporations.

Posted by TFF | Report as abusive

Excellent post, you’re echoing my thoughts exactly there. If you follow a classical low risk investment strategy, bonds are where it’s at; but as Bob Dylan said, “The times, they are a changing’…”

With interest rates essentially at zero, bonds have a lot more downside risk than for generations; and stock dividends in many cases are better than bond yields so even if the shares don’t rise in value investors could still make more from stocks than from bonds.

With fears of a global double dip recession fading, stocks could be the way to go. Unless the Western economies do double-dip while the Eastern ones do not, thus saving the world economy from such a fate. But what are the chances of that?

Posted by FifthDecade | Report as abusive

While I do agree with your analysis, there is a contra-positive: When this bond bubble bursts, watch out below.

Posted by Neubert | Report as abusive

A lot of people have abandoned stocks because they feel it is a rigged game. When 5 or 6 of the largest banks (or whatever you want to call them) make a profit trading EVERY day of the first quarter, while many individuals broke even at best, some of those individuals are going to wonder how can they compete (and if those firms made money every day trading stocks, then there were lots of people on the other side losing money every day). Add to the equation the fact that stock performance has not been paralleling many companies’ performance, and it shouldn’t be surprising that people have thrown in the towel on trying to figure out how to pick stocks.

In theory, you and all of the others are right about stocks vs. bonds. But that theory only proves true if you trust the system, and every day, less and less people trust this system. Not that any bank cares, because hey, they’re hitting their numbers, even without happy customers.

Posted by OnTheTimes | Report as abusive

Once upon a time, in the morning of the world, it was seen as perfectly natural and appropriate that stocks should yield more in dividends than bonds did in coupons. This was the equity risk premium–bonds were secured, but ownership was not. Everyone had forgotten this in a world where dividends had become passe and price appreciation was what real investors were after. Is the pendulum moving back? Could be.

Let us speak for a moment of the “horrific” Japanese deflation of the 1990s. The consumer price index–the concept most of us are referring to when we casually toss around the word “inflation”–averaged _plus_ .7 percent in Japan from 1991-2001. The producer price index averaged minus 1.1 percent. It’s only horrific when you step back and look at eleven years of it at a go–but it happened one day at a time, with very smart people trying their best to just muddle through Tuesday on Tuesday.

Collapsing real estate values…zombie banks…cash hoarding…it does strike a distant chord. I’d say residential real estate still has 15 or 20 percent to fall in real terms, and the biggest banks would turn to stone if they had to look directly at the market value of their assets.

I avoid long maturities, and I remain about two-thirds in equities of various kinds, because I aim to be long the global economy over the next five decades. But I just can’t see rates coming off the floor much before 2015, and I _can_ see my portfolio dropping to one-half equities without my lifting a finger. Having coupons coming to me in nominal dollars is quite satisfying.

Posted by ckbryant | Report as abusive

If you prefer to limit the single stock/sector risk SDY is an ETF that tracks the S&P High Yield Dividend Aristocrats Index. Based on its last four quarterly dividends and the current FMV it yields around 3.4%, similar to JNJ. The creditworthiness of the index would probably be rated below that of JNJ at this point in time but the benefit of diversification would make me more confidant of the creditworthiness of the index components over a ten year period. Of course it is still possible that the price of SDY will be lower ten years from now than today but if I had to choose strictly between a JNJ bond or the dividend fund I wouldn’t be buying the bond.

Posted by JohnOmeara | Report as abusive

I think that the biggest factor for equity valuations is still inflation expectations: as long as these remain low, the ongoing risk-adjusted value of an equity compared to a safe-as-chips treasury or even credit-worthy private sector bond will remain limited.

But inflation expectations rarely remain low forever… Once these return to the fold, equities will once more regain their limelight as the prima-donnas of a real-economy (as well they should be).

I realise that this discounts the prospect of a Japanese styled ‘deflation’ scenario, but really, the demographic situation in the US do not warrant such a process to occur and, despite there having been every reason for deflation to have stepped in over the course of this year, we are still currently (albeit marginally so) inflating…

As de-leveraging achieves its natural conclusion (after all, there is a limit to how much debt you can actually pay back), the return to leveraging should bring with it a natural inflationary push (let’s hope a gentle one) and give back once more that glimmer over the good old ‘stock’.

Now returning to your column post, if you yourself see current value in J&J credit, then sooner or later this will multiply itself over in earnings and in pricing power for J&J proper, feeding into inflation which in turn should further boost up equities…

Tariq Scherer

Posted by tariqscherer | Report as abusive

Here’s why corps can issue debt below their divvies:

Insurance companies hold bonds on their annual statements at amortized cost, provided they are investment grade rated and marked as “to be held to maturity.” Therefore, there literally is NO RISK in loss of value of the bonds, regardless of what interest rates do. Granted to some degree that’s an accounting fiction based on how the rules allow insurance companies to account for the value of the bonds intended to be held to maturity, and if there were true 100% mark-to-market it’d be different, but there it is.

Also, there is such thing as asset-liability management; an insurer needs $X in N years to pay an obligation. So they like to have a known payment amount and maturity of the asset in order to immunize that portion of their portfolio against interest rate changes. If they book a 10-year corporate against that obligation, it’s a known quantity; on the other hand, if they bought JNJ instead of JNJ’s debt, they’d constantly have to mark the position to market and see what kind of shortfall or overage they had against their obligations, and adjust for that shortfall/overage by selling/trading assets.

Stop thinking like everybody trades the same way, with the same objectives. It just ain’t true. And when it comes to bonds, think about the institutional players that are the powerhouse bond purchasers, and the accounting rules that encourage them to play that way.

Posted by algunoshombres | Report as abusive

Were I John Paulson I would arb that difference. It would be easy to go short the JNJ bond coupons and go long the stock dividend. I would have no problem whatsoever doing that with XOM, PG, or a handful of other stocks.

In essence if you think that a company is so safe that they can borrow money at 3% 10 years then the stock should be a good bet with a forward P/E of 10.

With a couple billion dollars and some leverage that would make a pretty neat fund… and one that would probably keep Paulsons name at the top of the hedge fund class for another decade.

Posted by y2kurtus | Report as abusive

Were you JP, you should.

People mistakenly think markets are efficient and that rational actors are maximizing utility, but they forget that utility is subjective. Insurance companies are willing to be the loser and subsidize trades like that arb, because they still get what they want out of it. It’s win-win. I could make the argument that insurers are stupid, and need to trade “rationally” under mark-to-market rules and @#$$ this accounting annual statement treatment, but it’s hard to convince them of that when their surplus is already volatile due to underwriting results. They tend to cling to the false stability of marking their held-to-maturity bonds at amortized cost, regardless of what they could actually sell them for, if forced to do so.

Those same accounting rules are why insurers, who allocate little to equities, lapped up CDOs, real and synthetic, like they were purple Kool-Aid, despite the real risks! After all, if they’re A-rated, they’re carried at amort cost.

The need to match assets to liabilities is also a primary reason why 30-years typically trade at lower yields than 20-years, BTW.

One shouldn’t assume (as Tilson does) that all participants in the market are after the same thing. :-)

Posted by algunoshombres | Report as abusive

I’m scared of equities these days, and plan on waiting for the 3rd plunge of 50% or more over the last 10 years before jumping back in. The recession may be over, but the depression is ongoing…

Posted by DetroitDan | Report as abusive

“The recession may be over, but the depression is ongoing…”

You’re right on the mark. This is the smartest sentence I’ve read this week.

Posted by yr2009 | Report as abusive

Thanks yr2009. I borrowed that from David Rosenberg…

Posted by DetroitDan | Report as abusive

Do you think there is a positive or a negative correlation between stocks and bonds? I compared prices of the S&P and 30 year bonds from 1996-2009 and found a very weak / negligible negative correlation (r= -0.110)

The ‘stock bond disconnect’ is long established.

Posted by bunter2010 | Report as abusive

The huge difference between the US and Japan is that US debt is owned by China,and Japan’s is owned by its people.

We aren’t going to get their deflation – but we ARE going to be even more vulnerable than they were. And they ARE going to have more options – once leaders there start using their imagination.

http://nbyslog.blogspot.com/2010/09/anal ysis-world-war-iii-gets-under-way.html

Posted by nbywardslog | Report as abusive

It also matters who is making the purchasing decision. If it’s a pension fund or a hedge fund that reports yield pre-tax, then the analysis you give is correct. If the investor is a high-net worth individual, then consider the after-tax consequences — next year it is likely that dividends will be taxable at a 20% federal rate, but interest at 39.6%. That skews the investment decision.

Posted by comment1 | Report as abusive

@ onthe times

thats the best comment i have read in a long time, and for many people will be a good warning, if they are thinking of investing in anything connected with financial casino… i guess it is not much better to keep the cash, but looking at everything, it still seems better than playing high stakes with crooks…

Posted by johny2 | Report as abusive

Enough money passes through Wall Street that it is possible for the traders to siphon off massive amounts and still leave a respectable return for small investors. Long-term investing is not a zero-sum game.

I know people are discouraged by the 1/2000 to 1/2010 returns, and fearful of the large bounces down and up in between, but they HAVE to realize that the situation today is very different than the situation in 2000. Ten years ago, expectations were sky-high and the economy looked great. Predictably, both fell back to earth and the market returns suffered. Today, expectations are in the toilet and people are talking “depression” and “double-dip recession”. Predictably, that will also moderate over time and the market returns will respond.

Investor sentiment may be a good predictor of short-term movements, but it is a CONTRARY indicator of longer-term trends. Because whatever the mood, it will eventually shift.

Posted by TFF | Report as abusive

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