Jumping on the Bond Bandwagon

Courtesy of Pacifica Partners

Pacifica Partners' Financial Post Weekly Column - Aug 16th 2010

Recent data shows that investors are flocking to bonds and bond mutual funds in overwhelming numbers. The image of the thundering herd comes to mind as economic fears and stock market volatility has instilled fear amongst investors. Recent comments from PIMCO, which runs the world's largest bond mutual fund, indicate that they are taking in over a billion dollars of capital from investors looking to invest in bonds.

The rout in interest rates has allowed corporations to borrow money from the bond market at some of the lowest interest rates on record. Recently, IBM was able to sell 3 year bonds paying only 1% in interest and Johnson and Johnson was able to issue ten year bonds that only cost the company 3.1% in interest annually.

For corporate America, things have seldom been better. It is estimated that US businesses have nearly $1.5 trillion in cash on their balance sheets and are able to borrow at the most attractive interest rates in decades.

The chart below compares the current dividend yield being earned by shareholders of IBM, McDonald's and Johnson and Johnson. By looking at the comparison, we can see that the shareholders (owners) are getting paid almost as much or more as the lenders (bond owners). It should be kept in mind that these companies have annual dividend growth rates that that are 16.80%, 28%, and 14% respectively.

If these companies were to continue to grow their respective dividends over the next ten years at the same rate as the last ten years, then the income earned by shareholders would far exceed the income received by the bond holders of these companies. For example, in the case of Johnson and Johnson, if the company could continue to increase its dividend for the next ten years as it did for the last 10 years, its current dividend yield would rise to almost 14% while the bond holders who just purchased the recent bond issue highlighted below would continue to receive a fixed 3.10% interest rate for 10 years.

In the case of Johnson & Johnson, if the company were to continue to increase its dividend for the next 10 years as it did for the previous ten years, then today's 3.70% dividend yield would rise to about 14% (of cost).

To be clear, the buyer of Johnson & Johnson's bonds is willing to receive a fixed 3.10% in interest for the next ten years whereas the shareholder has the potential to earn a rising stream of income that would increase as the dividend rises over time.

Looking at the facts at face value, it would seem hard to find a valid reason to be a buyer of bonds for an intermediate to longer term period. However, as debate rages within the markets about whether or not the economy will enter into a double dip recession or even if deflation is about to take root , it can be seen that investors are being driven at least in part by fear.

As history has shown time and again, the fear trade usually feels like the right thing to do but it is often the wrong trade. While it is simply too early to say that the stock market is about to embark on a raging bull market like the 1980s or 1990s, one of the yard sticks that well known bearish investors have always mentioned as being evidence that the bear market was winding down or at least long in the tooth is seeing quality blue chip companies driven to extremely low valuations. Perhaps we are closer than we think.

Pacifica Partners Capital Management
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