Buying certain stocks as “bond substitutes” has been a fashionable trend in recent years.
A new emerging trend toward issuing 20-year bonds offers a happy medium between the low yields associated with 10-year debt and the extremely long maturities associated with 30-year debt.
Higher bond yields and a new 20-year bond make Verizon’s stock less appealing as a bond substitute.
There are at least two kinds of investors in Verizon's (NYSE:VZ) stock: (1) Those who own the company because they want equity exposure and/or the potential for long-term dividend growth, and (2) those who bought Verizon as a "bond substitute." In the low-interest-rate environment of recent years, buying certain dividend-paying stocks as so-called bond substitutes became quite fashionable.
The idea behind the bond-substitutes trend is to buy the stocks of certain companies paying dividend yields at levels that investors would have historically expected to earn from bonds. Or, at a minimum, a so-called bond-substitute stock should offer a "real" yield. Moreover, companies targeted as bond substitutes are expected to have stable sources of revenue and in some cases be regarded as "recession proof." Never mind the fact that stocks are at the bottom of the capital structure, and that there is no guarantee a stock will return your original investment the way an individual bond will (any particular stock might go up or down over an extended period of time). Bond-substitute investors demand certain yields from their investments, and they will get those yields no matter what it does to their portfolio's risk profile.
With a yield in excess of 4%, Verizon has been one of the companies targeted by the bond-turned-equity investors. Now, however, I think the time has come to test whether the idea of "bond substitutes" was simply a gimmick intended to motivate people to buy stocks, or truly a place to park one's money until yields moved higher. Two things have recently occurred that, in my eyes, should push at least some of the bond-turned-equity investors back to Verizon bonds. First, since the spring of 2013, yields have risen enough that rates in excess of 5% can now be captured on parts of the yield curve. Second, Verizon recently issued a new 20-year bond.
Despite the notable rise in yields during 2013, two problems still existed that made it difficult for bond-turned-equity investors to switch back to bonds. The first is that many companies have large gaps on their yield curves, with plenty of maturities up to 10 years and additional maturities of roughly 30 years. Between 10 and 30 years, however, there is generally not a whole lot of opportunities. Second, for those companies that did have maturities in the 10- to 30-year space (such as Verizon), the bonds were trading at prices way too far over par to make them attractive options for many investors. Recently, however, I've been noticing companies issuing 20-year notes, a welcome development that should ease the transition back to bonds for the true long-term-focused bond investors. The preferable thing about 20-year debt is that it often comes with coupons well in excess of 10-year debt, but so close to 30-year yields that it makes little sense to go after the 30-year bond. Additionally, by reducing the maturity by 10 years, without sacrificing very much yield, it shifts the risk-reward profile of a company's bond more in favor of buying than of avoiding.
Verizon's brand new 20-year debt, CUSIP 92343VBZ6, was issued with a 5.05% coupon and matures on March 15, 2034. It comes with a higher coupon than Verizon's 2041 and 2042 maturing notes and even yields more than the 2042s. I realize the 4.54% dividend yield on Verizon's stock is attractive. But I also think those bond-turned-equity investors who were using Verizon's stock as a bond substitute should carefully consider the risk-reward of sticking with the stock versus switching into the new 20-year debt.
To income-focused investors, a yield of 5.05%, reinvesting the coupons as you see fit, and getting a return of your capital at maturity may be an enticing option. Yes, the stock offers a 4.54% yield, a recent history of 2% to 3% dividend growth, and the potential for capital appreciation. So it all comes down to how much you value relative certainty over relative uncertainty. I think Verizon's new 20-year debt offers long-term bond investors a happy medium between the low yields associated with 10-year debt and the extremely long maturities associated with 30-year debt. Additionally, investors concerned that yields might head higher in the near future could scale into the bond position, just as equity investors might average into a position on the way down.
In my mind, the new 20-year debt means Verizon's stock should no longer be considered a bond substitute. The new notes offer an alternative for those who are bond-investors-at-heart to capture a respectable yield. And if you have the wherewithal to hold the bond to maturity, you can ignore the number one thing that bond bears cite as the reason to avoid longer-term debt: duration risk. As an individual bond investor who always buys with the intent to hold a bond to maturity, I never care about the mark-to-market movements of a bond's price. Instead, my focus is on credit risk. Perhaps you have concerns about Verizon's credit risk over the next 20 years. But if you do, you also wouldn't want to own the stock. For true bond investors at heart, the higher yields of recent months combined with the new 20-year debt makes it difficult to justify using Verizon's stock as a bond substitute. Every fixed-income investor will have his or her own trigger at which the yield and maturity combination of a bond tilt the risk-reward from that company's equity back to the debt. Concerning Verizon, from my perspective, a greater than 5% yield at 20 years or less to maturity does the trick.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.