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Bonds can play an important role in diversifying a stock portfolio, although the current bubble in bond values places excessive stress on that benefit. Today’s yields don’t make sense to investors. While the Fed needs to keep interest rates at low levels to strengthen the pace of recovery, investors who flee stocks for the “safety” of bonds will get hammered. Those who are not distracted by the equity market’s volatility and focus on its exceptional current value relative to its long-term prospects will be handsomely rewarded.

There are now so many examples available to demonstrate that bonds are vastly overpriced that it is hard to avoid concluding there’s a bubble in bonds. Last week, the AAA-rated State of Utah issued tax exempt bonds, including a 2017 maturity at a yield of 1.73%. Investors are extremely likely to get their money back in 2017 from this high quality borrower, but the buying power of their capital will not grow at all unless inflation remains below 1.73% on average for the next seven years. A mere 2% average rate of inflation will provide these bond buyers with an annualized real loss of buying power of 27 basis points. The risk here, a risk that I consider a highly likely outcome, is that these investors will neither earn a real return on their principal nor a real return of their principal on this very “safe” investment. Nonetheless, the bond issue sold out quickly.

In the corporate market, numerous companies have issued bonds at lower yields than are currently paid by their common stocks. This is most nonsensical for companies that have a history of raising dividends most every year. McDonald's (NYSE:MCD), which has a long history of annual dividend hikes, recently sold a 10-year bond issue at a yield of 3.5%. This year’s dividend hike, recently announced, raised its stock yield to 3.2% and next year’s should exceed the bond coupon for this blue chip. Over ten years, the stock is likely to leave the bond in the dust. IBM issued 3-year notes at 1.0%, while the shares pay 2.0%. But, Microsoft (NASDAQ:MSFT) topped this by raising almost $5 billion in four tranches, each of which was remarkable. The $1 billion 3-year tranche at 0.875% is just an incredibly low return to be earned for three years. It is a reasonable bet that inflation will exceed the coupon in each and every year. The five-year note pays 1-5/8%, little enough that it may be easily exceeded by inflation every year and the coupon is also taxable. Perhaps even more impressive was the $1.0 billion 10-year tranche at 3.00%, which is taxable and exposed to inflation risk and barely exceeds the 2.6% dividend yield. Do investors really think they will do as well in the bond compared to the stock over ten years? Lastly, there’s a 30-year issue to yield 4.5%. By then, Microsoft’s dividend might be some multiples of the bond coupon. One of our brokers offered us a Dow Chemical (NYSE:DOW) 7-year note rated BBB- yielding 4.10%, suggesting it was “attractive”. Someone might construe the Dow bonds as cheap only in contrast to the more highly rated Microsoft bonds. We passed on all these bonds and all sold out quite readily.

So, what do these examples imply? There are several important implications. First, such interest rates reflect the enormous demand by retail investors for bonds over stocks, a conclusion reinforced and reflected in the ongoing capital flow out of stock funds and into bond funds. Just as tech stocks were the fad of the late 1990s, bonds are the fad of today and their current valuations make little long-term sense. Sooner or later, bond buyers will see their portfolios get hammered.

Second, the Fed has helped orchestrate this circumstance by providing substantial excess liquidity to the financial system to help promote a refinancing of private debt and to strengthen the economic recovery. With unemployment near 10% and economic growth still too slow to absorb many job seekers, this policy is entirely appropriate. Therefore, it is very likely that this policy will continue for as long as it takes to get a faster growing economy. And sooner or later, the Fed will get its way, so investors must invest accordingly. This suggests households should be positioning for a stronger recovery and refinancing now, while they can. Corporations are already doing this. Debt issuance is very high, even though companies sit on $1.7 trillion in cash. (Yes, some cash is trapped in overseas subsidiaries, but this doesn’t negate that corporations are flush, profit margins are wide and, yet, companies are selling debt at a record pace while rates are historically low.) Companies are borrowing the cheap money while they can. Similarly, to the extent possible, households should roll their credit card debt into any mortgage refinance and lock up prevailing low interest rates for the long-term. Moreover, for exactly the same reasons companies are selling bonds and households are refinancing debt, investors should be avoiding buying bonds and favor stock purchases, instead. It is simply contradictory that households would refinance mortgages at the lowest rates in their lifetimes, while pouring investment cash into bonds. Instead, they should be pouring money into stocks and locking in record low interest costs via debt financing.

Alas, this never happens. While everyone knows the maxim “buy low, sell high”, most households do exactly the opposite. Households tend to follow recent market trends for good and, mostly, for bad. So the rise in gold prices attracts new investors, driving up gold prices, until the point of collapse as occurred more than 20 years ago. Gold prices will collapse again. Or in the 1990s, households just kept buying tech stocks until they collapsed. Now, the flows go into bonds. And it will become so very obvious, with full hindsight, when the bond bubble bursts.

Disclosure: No positions

Source: The Bubble in Bonds