- Money Morning Australia

What US ‘Junk’ Bond Yields Tell You About Stock Prices

Written on 08 August 2012 by Kris Sayce

Our old pal, Australian Wealth Gameplan editor Dan Denning has just returned from a big investment conference in Vancouver, Canada.

He tells us the subject on most people’s lips was the so-called bond bubble.

That’s the theory that US government bond yields are so low, they couldn’t possibly go any lower.

Well, many thought that in 2010 when the 10-year US government bond yielded 3.5%. The belief was that no-one would accept less than that in return for lending money to the government for 10 years.

They were wrong.

Today, the same US government bonds yield 1.62%. Investors will lend to the US government for 10-years at super-low rates. So, is there a bond bubble or not? And either way, what does it mean for your investments? We’ll look at that today…

Of course, you’ve got to remember that it isn’t just normal investors piling into government bonds. The biggest investor in US government debt is the US Federal Reserve.

So one branch of the government owns the debt of another branch of the government. (Yes, we know the Fed is a private company, but let’s be honest, one has consumed the other…arguably the Fed has consumed the State.)

And no longer are central bankers quietly running the economy in the background. The global cabal of bankers now openly run and direct governments.

Even last weekend’s edition of the Australian Financial Review admitted it with the front-page headline, ‘Exclusive: The man who really runs Australia’. Underneath was a photo of grim-faced Reserve Bank of Australia governor, Glenn Stevens.

A New Public Holiday

And to understand the influence of central banks, you only have to see the hysteria leading up to the RBA’s interest rate decision.

Yesterday, one online property newsletter devoted no fewer than seven out of eight headlines to the RBA decision…along with the RBA emblem and a heading proclaiming it was ‘Interest rate decision day’.

It won’t be long before the blind public honour central bankers in the same way as other prophets. Perhaps soon we’ll celebrate ‘Interest rate decision day’ with the exchanging of gifts or the giving of chocolate.

On the other hand, maybe they’ll precede each decision with a lavish parade with cheering crowds…Nuremburg style. We don’t know about you, but the RBA emblem has something of a menacing, totalitarian look:

It reminds us of another menacing symbol.

But maybe that’s just us. Anyway, there’s no doubt bond yields have tumbled. Even the 10-year Aussie government bond yield is now only 3.34%. That’s much lower than a year ago when the rate was 5%.

But what about other yields? Such as corporate bonds and dividend yields.

A Mixed Bag of Yields

If you look at the yield of A-rated corporate bonds, like US government bonds, these too have sunk to multi-year lows:

Source: www.epreferreds.com

A-rated two-year bond yields stand at about 1%. That’s much lower than the 5% yields before the financial meltdown in 2008. And much lower than the 12% peak during the meltdown.

But yield behaviour isn’t uniform. Yes, government and corporate bond yields are a lot lower than five years ago. But the same isn’t so for another group of corporate bonds…junk bonds.

As the following chart shows, US junk bond yields, which are currently just over 7%, are trading at their 2003-2007 average:

So what does that mean?

Well, arguably, despite junk bond yields appearing to be relatively high at 7.6%, it’s worth remembering that Italian and Spanish 10-year bond yields are 5.93% and 6.78% respectively.

In other words, investors put high-risk CCC-rated bonds on an equal risk-rating with Italian and Spanish government debt. That’s despite analysis from the Stern School of Business showing CCC-rated bonds have a 22% chance of default within a year!

It just goes to show the market’s lack of confidence in the Eurozone.

5 Stocks Still to Buy

The other yields still looking good are stock market yields. The only question is whether these yields are sustainable. In other words, are dividend yields high because investors expect companies to cut the dividend?

That’s possible. But if it does happen, it suggests stock prices have this potential already built in. Meaning, if companies do cut dividends, the price decline may not be too severe.

In our view, that makes it worthwhile to punt on a few beaten-down blue-chip stocks.

A few weeks back we listed five stocks that you should think about buying for your share portfolio. The stocks are a mixture of growth and yield. We recommended you look at Harvey Norman [ASX: HVN], JB Hi-Fi [ASX: JBH], Myer Holdings [ASX: MYR], Qantas [ASX: QAN], and Toll Holdings [ASX: TOL].

We still rate them as a buy today for anyone who’s looking to add a few stocks to their portfolio. (Although remembering what we wrote yesterday, it doesn’t mean you have to buy all five. Any two or three of these stocks have the potential for growth and dividends…providing you’re happy to take on the risk.)

The point we’d make is you can wait a long time for an obvious bubble to pop. Whether it’s house prices, stocks or bonds, asset prices have a habit of going much higher (or lower) than most think possible.

So if you’re sitting on the sideline, waiting for the bond bubble to burst and the economy to collapse before you buy stocks, good luck, because there’s a chance you could have a long wait.

We don’t know when the US bond bubble will burst. It could be next week, or it could be in 10 years. But we know one thing for sure, we’ve got no intention of sitting around waiting for it to happen.

Because right now, for investors who are prepared to stick their necks out and take a calculated risk, there are a whole bunch of stocks selling at discount prices.

As we’ve said many times, that doesn’t mean investing your whole wealth in the stock market. But if you don’t have at least a 10-20% exposure to top quality blue-chips and a 5-10% exposure to speculative small-caps, you’re potentially missing out on some big gains in the years ahead.


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