The bond rally that never stopped

Taking the long view - back - at stock and bond market valuations gives rise to some intriguing thoughts. Over the last 25 years, the S&P 500 stock index - a reasonable proxy for the health of the US corporate economy - has risen from a level of 100 to 1500, and has more recently corrected to the 1200 level which is where it roughly sits today. Over the last 25 years, 10 year US Treasury bonds have seen their yields fall (and thus their prices rise) from around 16% in 1981 to below 4% in 2003, and to roughly 4.25% today. (Resistance sits at the rather incredible 3.11% of June 2003, the last time a deflationary scare took hold of the popular investment psyche.)

Charts, however, do a better job than a thousand words: the rising long-term stock chart looks like the left hand side of an Alp; the descending long-term bond yield chart looks like the right hand side of an Alp. Look at it another way: US stocks enjoyed a monumental rally which came to an abrupt halt five years ago; they then collapsed, and having retraced roughly half of their subsequent falls, the jury is now out (though on the basis of traditional metrics like price / earnings and dividend yield, we think the US equity market looks expensive. Since 1871, for example, the average dividend yield on the S&P 500 has been 4.6%, versus the miserable 2% on offer today. Stock buybacks may be good for option-remunerated executives, but they're much less useful for shareholders if the stock price falls). But look at bonds - or more specifically bond yields - over the same period and you realize that the bond rally never stopped. The decoupling between these two asset classes surely points to some big problems potentially ahead. This despite the fact that, as Morgan Stanley's Stephen Roach points out,

'Fully five years after Nasdaq 5000, the federal funds rate remains basically 'zero' in real terms'.

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Where bond prices go from here, both in the North American and European markets, is the trillion dollar question (a trillion being roughly the amount of dollars printed since you started reading this piece). We are inclined to believe that the only rationale for global bond yields at current levels is widespread and probably unjustified fear of impending deflation. (Fears of economic slowdown, which is hardly the same thing, are probably better founded.) Current yields certainly are a poor reflection of the future supply of government paper. (Standard & Poor's estimate that global sovereign borrowing will reach $4.1 trillion in 2005, of which the US will account for roughly $800 billion.) Those slender yields may, however, be a good reflection of mass hysteria or plain confusion.

Let's take a closer look at what 'yield' actually represents. The 10 year US Treasury bond currently yields approximately 4.25%. Core consumer price inflation in the US sits at 3.1%. Bond investors, therefore, are currently earning a real return of roughly 1.1% per annum - which is a wafer thin margin given the extent of official manipulation of the inflation data. Bloomberg defines 'yield to maturity' as follows: the percentage rate of return paid if a security is held to its maturity date. 'The calculation is based on the coupon rate, length of time to maturity, and market price. It assumes that coupon interest paid over the life of the security is reinvested at the same rate.' So that 4.25% headline return from bonds also assumes that the investor, and we know someone is hoovering up this stuff, and we think he lives in Asia, is patiently going to sit and reinvest his coupons into the market over the lifetime of the bond without touching the cash. That 4.25% will put the investor at the mercy of future interest rates (which the entire market believes are going up), inflation and - unless the US administration starts to take the budget deficit seriously - eventually credit risk.

Foreign non-dollar investors also have currency risk to worry about and - unless the US administration starts to take the trade deficit seriously - all those foreign investors may lose their appetite for the supposed 'safe haven' of US government paper when they start seeing minus signs in front of their account balances. And that 4.25% assumes that the investor holds to maturity. It is a reasonable assumption that many investors, both private and institutional, will not hold to maturity - in which case, they'll also be vulnerable to market risk, and are buying government bonds at their most expensive levels for 25 years on the back of not much more than price momentum fuelled by the madness of crowds. Doesn't this sound a bit like purchasing Nasdaq in March 2000?

The problem with the global deflation story is that it's, in our view, a low probability outcome but one with grave implications if it comes to pass - at least one hedge fund manager has suggested to us that the last decade in Japan was merely the dress rehearsal and the rest of the G7 will be the main event. The pragmatic decision for the unconstrained investor must surely be to take the threat of deflation seriously without burning too many asset bridges along the way. In bond terms, that argues in favour of concentrating on high quality (government) credit, de-emphasising corporate credit and avoiding junk bonds like the plague. This would be the case even if the meagre credit spreads currently available in the market didn't make the conclusion more obvious. In equity terms, that argues in favour of broadly defensive companies which are cash flow generative and avoiding heavily indebted companies like the plague.

A Bloomberg search by ratio of total debt to common equity in US markets throws up the following names potentially vulnerable to a credit crunch: UST (1506%), Goodyear Tire (7801%), Freddie Mac (2740%), SLM (2659%), and then a bunching of investment banks, including Lehman Bros (2164%), Morgan Stanley (2068%), Bear Stearns (1894%), Merrill Lynch (1456%) and Goldman Sachs (1366%). General Motors (1139%) and Ford (1033%) fall just behind. Apologists for the brokers will undoubtedly deploy some kind of pleading relating to their unique capital structure - but in a deflationary environment, they would also look uniquely vulnerable, since pretty much all their business lines would get impacted at the same time. (Coincidentally, fund manager and Bloomberg columnist John Dorfman has performed the same exercise but in reverse. His 'low-debt' picks for 2005 include: Exxon Mobil, Old Republic International, SanDisk, Heidrick & Struggles and Timberland.)

A Bloomberg search by gearing in UK markets throws up a list which includes the following candidates potentially vulnerable to a credit crunch here: Halfords (8335%), Imperial Tobacco (3327%), BSkyB (1195%), National Grid (1092%), John Laing (1006%), AWG (667%), Taylor Nelson (535%), BT Group (442%), Grainger Trust (421%) and Allied Domecq (405%). Note how much less heavily geared UK companies typically are versus their US rivals - or, to view it from a different perspective, how much less accommodative and more realistic the Bank of England has been on monetary policy.

Tim Price, Senior Investment Strategist, Ansbacher & Co Ltd.