As is evident in the SA community, the vast majority of investors focuses on the dividends of stocks in order to achieve the retirement goal. While this is not unreasonable, investors should always check out whether they can achieve their retirement goal via the corporate bonds of some great companies. To be sure, in the case of Yum Brands (NYSE:YUM), the bonds currently offer a screamingly better risk/reward profile than the stock thanks to the valuation of the two assets. Investors should not ignore this great gift of the market.
First of all, the stock is currently trading at 22.5 times this year's expected earnings so it is not hard to realize that it is out of bargain territory. Therefore, investors who are holding the stock for its 2.2% dividend should be aware that there is significant downside for the stock, particularly if the Chinese economy significantly slows down. Even if the company does not face any strong headwind, the potential upside is limited from the current stock price while the dividend yield is nothing to celebrate about.
On the other hand, the 6.875% bonds of the company that expire in 2037 currently trade around 97 and hence they offer a 7.1% annual yield for the next 21 years. Hence investors who purchase these bonds now are positioned to quadruple their money in 21 years. This is an exceptionally high yield for the bonds of a stalwart like Yum Brands. For instance, the bonds of other stalwarts, such as Coca-Cola (NYSE:KO), Pepsico (NYSE:PEP), General Mills (NYSE:GIS) and McDonald's (NYSE:MCD), which have a similar duration (about 20 years), currently yield only about 4% per year. Therefore, it is surprising that the bonds of Yum Brands offer such a high annual yield at the moment.
The reason is the downgrade of the bonds of the company by Moody's to the junk category about 6 months ago. Moody's based its decision on the announced spin-off of Yum China division and the intention of Yum's management to return all the proceeds to its shareholders via dividends and share repurchases. While the company now has a strong balance sheet, with net debt $6.6 B (just 4 times next year's expected earnings), the spin-off and the distribution of the proceeds will render the resultant company much more leveraged than the current entity. Moody's also stated that it would downgrade Yum's bonds even further if the company maintained its aggressive distribution policy for long and exceeded some key levels, such as Debt/EBITDA above 4.0.
Given the above, some investors may claim that they never consider junk bonds and hence they are likely to ignore these bonds. However, this is an exceptional case. More specifically, the downgrade has not resulted from business deterioration of the company or competitive threats. The downgrade has simply resulted from the aggressive distribution policy of the management, which wants to reward its shareholders to the extreme. This is a totally different case from the vast majority of junk bonds. To be sure, the company is on track to grow its earnings per share by 15% this year and 13% next year so it is clearly in a growth trajectory. As soon as the proceeds of the announced spin-off are distributed to the shareholders, the company will probably start reducing its debt thanks to its prospering business.
The only concern for the bondholders is a very adverse scenario under which the company will face great business deterioration and may have a problem servicing its debt. However, in such a scenario the company has many layers of defense. More specifically, it will first eliminate its share repurchases. As the company currently spends excessive amounts on share repurchases (it spent all the earnings on buybacks last year), the elimination of share repurchases will almost certainly leave the company with sufficient cash to keep servicing its debt. In the extreme scenario that this measure is not sufficient, the company will have to reduce or eliminate its dividend in order to keep servicing its debt. Therefore, the company has many layers of defense, which protect its bondholders.
Even better for the latter, if the economy experiences a recession, the company will probably decimate or eliminate its share repurchases, just like most companies do. Therefore, in the event of a recession, the bondholders can rest assured that the company will preserve more cash to keep paying them. All in all, there is a win-win situation for Yum's bondholders. Either the economy keeps growing and the bondholders will not have any problem or the economy heads south, in which case the company will become very conservative with its cash. In both cases the bondholders will not face any problems.
From the above it is evident that the bondholders of Yum Brands will almost certainly earn 7.1% per year for the next 21 years. While this is somewhat lower than the historical average annual return of S&P (NYSEARCA:SPY), which is about 10%, the much safer profile of the bonds renders them a much better investment right now. Although 7.1% is less than 10%, it should be noted that the full annual yield of bonds is distributed every year and is thus available for reinvestment whereas S&P distributes only a 2% dividend per year. Therefore, even though Yum's bonds may have a lower total return, the reinvestment feature renders them superior. Moreover, while the historical average annual return of S&P is about 10%, it is likely to be much less from now on, as the index current stands near its all-time high. Even worse, the US debt as a percent of GDP currently stands at an all-time high and hence the US economy will have to deleverage at some point in the future. That will take its toll on the future returns of S&P. Therefore, given the above factors, Yum's bonds become even more attractive compared to S&P.
Of course investors who consider purchasing the long-term bonds of Yum Brands should be well aware of the risk of rising interest rates. More specifically, when interest rates rise, the price of long-term bonds drops. This means that the bondholders may incur temporary, paper losses if interest rates rise significantly from their current levels. However, given the lackluster growth of the US economy, interest rates are not likely to rally in the next few years. As the Fed has proved its conservatism, it is not likely to raise the rates by more than 0.5% per year in the next few years. Therefore, if there are any temporary, paper losses on the way to the expiration of Yum's bonds, those paper losses are likely to be limited.
Moreover, interest rates have remained above 7% only for a few years throughout the US history (see the chart below). Even if they do rise above that level, the bondholders of Yum's bonds earn 7.1% right away so the superior returns of the bonds in the first years are likely to outweigh the potential opportunity cost of possibly higher rates in the distant future. All in all, when the average return is so attractive, investors should not try to time the market, at least in my opinion.
To sum up, it is amazing that a growing stalwart has bonds that offer a 7.1% annual yield while the 20-year bonds of most other stalwarts currently offer about 4% per year. This investment opportunity has resulted, not from business deterioration, but from the aggressive distribution of Yum Brands to its shareholders via dividends and share repurchases. In any case, in 21 years from now, people will still be eating Pizza Hut, KFC and Taco Bell. Therefore, investors can lock this exceptional yield and thus quadruple their money in 21 years. In this way, they will achieve their retirement goal with the least possible risk and the best possible sleep throughout the whole period.
Disclosure: I am/we are long YUM.
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.
Additional disclosure: I am long YUM bonds.