Bonds: Is the Glass Half Empty or Half Full?

Includes: BAB, BIV, IEF, TBT, TLT
by: Jim Farrish

The pessimists have moved out of stocks and into safer havens. Yet, fundamentally, cash flow and dividends show stock values are attractive. The big opportunity could lie in the simple fact that fundamentals in areas such as profitability versus valuations show a disconnect in terms of perception versus reality. Individual investors are perceived to have lost faith in owning individual stocks or stock mutual funds and the money drain from both has been significant over the last twelve months. $57 billion has been withdrawn from stock mutual funds since May 6th (flash crash) according to Investment Company Institute, showing an escalation in fear. $597 billion has poured into bond mutual funds, according to ICI, in response to the decline in stock prices since July 2008.

Is the shift to bonds a misplaced trust? The yield on the top 70 stocks in the S&P 500 averaged a 3.6% dividend (as of September 30), yet the yield on Vanguard Intermediate Term Corporate Bond ETF was yielding 3.9%. Breaking down the risk/reward opportunity between the two bonds show a greater risk at current valuations. Confidence in stocks and the overall equity market is currently at a low. The last ten years of no returns based on the S&P 500 has played a key roll in investor confidence.

Negativity towards stocks have not been this bad since 2003, coming off the tech wreck of the dot coms. There are signs of improvement in the economy. Retail, consumer confidence, manufacturing, services and home sales are improving. Albeit not at record setting pace, but gradually improving. Bloomberg shows earnings growth for 2010 at 36% and 15% for 2011 on the S&P 500 index. The P/E ratio of the S&P 500 is currently 14.2 based on the 2010 estimates, which is below the historical average of 17, leaving room for growth. At some point there will be a catalyst and it will be sustainable relative to growth. The only question is will you participate, or watch with the rest of the bondholders?

Are bonds in a bubble? Bubble, what bubble? The inflated prices on bonds is a matter of opinion to some and to others it’s a fact. Who is right? Only time will settle that argument, but as investors we have to be aware of the current risk. In their simplest form bonds are driven by interest rates. When rates rise, bond prices decline. When rates decline, bond prices rise. Since June 2007 the yield on 10 year Treasury bonds has declined from 5.25% to 2.5%. In turn, the price of bonds has risen more than 25%.

The Federal Reserve overnight funds’ rate stands at zero; the question begs, how much lower can rates move? The Fed is in the process of QE2 (quantitative easing part 2), buying up to an estimated $500 billion in Treasury bonds. Theoretically, this will keep interest rates low and money supply liquid to stimulate borrowing and expansion of the economy. The impact is temporary (see QE1 results). All of this activity to prop up bonds will end, and with it there will be a correction in bond prices. (See the tech wreck in 2000, housing prices in 2007, and derivative prices in 2008.) All bubbles pop. It is just a matter of when.

$234 billion has been poured into bond mutual funds alone over the last six months, according to Investment Company Institute. If the trend for deposits reverse it could result in accelerating downside risk for investors. Thus, precaution is needed relative to any bond investment and special attention paid to bond mutual funds.

The other risk factor facing bond investors is inflation. Currently, that doesn’t exist, but should the economy start to recover at a faster rate, it will become an issue. Currently rising rates seem to be a stretch of the imagination as much as inflation. However, both are real risk and in time are likely to impact the price of bonds. As an investor you cannot manage your money based on what may happen, but on what does happen. Until rates start to rise and inflation heats up, hold tight, but keep your eye on the warning signs.

Disclosure: No positions