As the risk trade morphs, investors of all flavors are jumping the equity ship in to bonds. First, it was US Government bonds then Municipal bonds and now Corporate America wants is slice of the cheap money pie. I applaud Corporate America for taking advantage of such insanely low rates especially if they put the proceeds to good use expanding business, restructuring higher cost debt or something accretive to shareholder value. In fact if a corporation has the ability to get money at historically low rates and does not to restructure existing debt you have to question the management of the company as to why they are not taking advantage of this window of opportunity to become leaner and meaner.
The flip side of this trend born from the risk trade is a question for you dear reader. Does it make sense for an investor to purchase the debt of the companies?
Let’s take IBM for example, who just sold bonds in an offering at 1% for a three year note. Investors are figuring that they are doing better by about 25 basis points over the comparable term US Treasury. In essence the market is saying that IBM debt is nearly comparable in quality to the “riskless return” of a US Treasury, since the US Treasury has a yield of .8% at the time of this writing. So if IBM has a “credit risk” nearly comparable to the US Government is one really better off holding the bonds of IBM at 1%.
In my estimation investors are short changing themselves with risk adverse thinking. Here is why I believe the bonds are a less attractive choice than the equity at this time. Starting with the equity itself, IBM has a forward PE of 10.21 and a PEG ratio of .97. The industry average for the sector that IBM is in is a PE of over 31 and a PEG ration of 1.57, so versus its peers it is reasonably priced. Moreover, the PE ratio of IBM at the trough of the 2009 bottom was 9.65 so on a forward basis it is pretty close to the panic conditions, even while the company and economy are not at panic levels.
If you purchase the IBM bond you can hold it and receive all your principal back and collect the 1% after 3 years. The type of investor who buys this is the CD investor, because they believe that the company won’t go bankrupt and they will get their money bank and some interest. If you follow that same logic then why not buy the equity stock of IBM. While it is true that the price could fluctuate and there is no true guarantee that if you hold the stock in three years it will be worth exactly what you paid, although based upon the markets risk assessment there is reason to believe it will be equal or higher. As a result of taking on the risk of fluctuation one is compensated with a 2% yield and a chance for appreciation. Sure one might get some appreciation on a 1% bond if rates fall lower, but the odds are it won’t be that significant and if it is the situation could be very dire.
If one purchased the equity one also gets paid the dividend to hold the shares just like the coupon on the bond. The difference is that IBM has raised their dividend 25.3% over the course of the last three years where as the coupon on the bond will not be raised. So a share holder gets paid to wait and as the company goes about its business and IBM has been raising the dividend giving the equity holders a raise each year. So long as IBM performs and it is in a sector that has done reasonably well for the past couple years it should keep raising the dividend providing a means of income growth and potential capital appreciation, can a bond at 1% do that? Not likely.
There are other companies in the market with even better dividends and track records of raising them as well. The key is to buy dividend paying companies that have a track record of raising them at a time of reasonable or undervaluation of the share price.
Disclosure: I own IBM shares