TCS Daily

The Debt Bet

By James K. Glassman - September 24, 2002 12:00 AM

If you're thinking of bailing out of the stock market, you're not alone. Frantic investors are moving their money out of stocks and into bonds and money-market funds - that is, out of equity and into debt. Investing demands choosing, and, instead of owning pieces of businesses, many investors have chosen to lend money to them, and especially to governments. Lending is a lot less risky in the short term than owning.

New figures released by the Investment Company Institute show the trend dramatically. For the first time since 1995, Americans in July had less money invested in stock funds than in bond and money-market funds. At the height of the boom in 1999, stock (equity) funds had $4 trillion in assets while money-market and bond (debt) funds had $2.4 trillion. Now, debt funds lead equity funds, $3.3 trillion to $2.8 trillion.

Is this trend sensible? Probably not.

As I have written, oh, about a million times in this space, history shows clearly that stocks return far more than bonds in the long term, and carry roughly the same risk. In the short term, debt is much less risky than equity, and there are stretches where debt returns more as well.

Unfortunately, after talking to bond experts, my strong suspicion is that most of the money pouring out of equity and into debt is long-term - retirement assets, for instance - and ought to be more patient capital. The people who are flocking to bonds and cash (that is, very short-term debt, including money-market funds, Treasury bills, bank certificates of deposit and so on) may intend to get back into the market when things start looking up, but they are doing what most sensible financial advisers tell them not to do - they are trying to time the market with their long-term savings.

But who can blame frightened investors for abandoning a sinking stock market and seeking refuge in the apparent safe harbor of bonds?

Rather than admonish readers for their lack of discipline, I'll try this week to guide them to a sweet refuge or two.

First, however, understand the problem right now with debt: You don't get much for your money. When the economy is sluggish, the best companies aren't doing much borrowing, so the demand for loans is low. In addition, when times are tough, the Federal Reserve pumps liquidity (cash) into the economy to try to get it going again. The supply of money for loans is abundant, and when the supply of anything is high and the demand is low, the price - or, in this case, the interest rate - is low, too.

In fact, rates are abysmal. On Friday, a U.S. Treasury bond (technically called a note, but let's keep it simple), maturing in 10 years, was yielding (that is, fetching an interest rate of) just 3.8 percent. A five-year bond was yielding 2.8 percent; a two-year bond, 1.9 percent.

Prefer to make more money by lending your cash to a U.S. company with a high credit rating? Ten-year, AAA-rated corporate bonds last week were yielding 4.8 percent; two-year bonds, 4.8 percent.

What about international debt? On Friday, a British government bond maturing in 10 years was yielding only 4.4 percent; a French government five-year bond, 3.7 percent; a Japanese 10-year bond, 1.3 percent. Low, low, low.

Meanwhile, U.S. Treasury bills (those are bonds that mature in a year or less) are yielding only 1.6 percent, the lowest rate in 34 years. Think about this yield for a second. Figures released Wednesday show that the inflation rate over the 12 months ending Aug. 31 was 1.8 percent. If that rate continues over the next year, then the money you put into a T-bill now will actually decline in purchasing power when the government repays your principal. And it gets worse. If you are in a 30 percent federal tax bracket (interest on all Treasurys is exempt from state and local taxes), your after-tax yield is just 1.1 percent. Invest $10,000 and you will clear $110 after taxes for a total of $10,110, but, meanwhile, thanks to inflation, something that costs $10,000 today will next year cost $10,180.

T-bills and other forms of interest-bearing cash investments are merely parking places for your money. But, on average since 1926, investors have earned 3.8 percent from such vehicles, or about 0.7 percent more than inflation. At today's rates, cash just isn't very attractive.

What is? I have a few suggestions:

• Municipal bonds. Interest on muni bonds, which are issued by state and local agencies, is (with a few exceptions) exempt from federal taxes. Like Treasurys, muni yields are at historic lows. Last week, the Bond Buyer's index of 20 highly rated general-obligation bonds (with the full taxing power of governments behind them), maturing in 20 years, carried a yield of just 4.77 percent, the lowest since 1968. George Friedlander, manager of fixed-income strategy for wealthy clients at Salomon Smith Barney, said that last month was the third-best ever for selling munis to individuals.

Still, while muni rates are low, in many cases they are considerably higher, after taxes, than Treasury rates. Richard O'Brien of Folger Nolan Fleming Douglas in Baltimore, told me that, "without question," his clients were pouring into munis and that bonds maturing in about 10 years "appear to be the best value" right now.

For example, the City of Frederick, Md., recently borrowed $26.5 million from investors in a series of munis rated Aa3 by Moody's Investors Service (a very good rating, though not the best). Frederick bonds that mature in September 2012 yield 3.3 percent. If you live anywhere in Maryland or the District of Columbia, interest is exempt from federal, state and local taxes, which, in the top bracket, come to 43 percent.

The "tax-equivalent" yield of the Frederick bonds is 5.8 percent, a number derived by dividing the yield of 0.033 by 1 minus the tax rate of 0.43. In other words, the Frederick bonds yield as much as a fully taxable bond yielding 5.8 percent.

Rates on shorter-term munis are less enticing but still worth considering. The average two-year Aaa-rated muni was yielding 1.55 percent on Wednesday. At a tax rate of 35 percent, that's a tax-equivalent yield of 2.4 percent, compared with 2 percent for a Treasury and an average of 2.5 percent for a top-rated corporate bond.

• High-yield bonds. Speaking of corporates . . . in general, I don't like them much. In these tough economic times, a highly rated 10-year corporate bond is yielding less than 1 percentage point more than a Treasury with the same maturity. The risk isn't worth the additional reward.

But, surprisingly, debt issued by companies with lower credit ratings - called "high-yield" or "junk" bonds - carry a decent risk-reward relationship today. In a recent letter to clients, Byron R. Wien, the Morgan Stanley strategist, told how he brought together some smart portfolio managers last month. "Yield came up as a noble investment objective," he wrote, "and one manager said that bonds were the real opportunity for equity investors." The point was that "some 'fallen angel' high-yield bonds were providing current returns of more than 10 percent with a minimum of default risk. . . . In a low-total-return equity environment, these returns are attractive."

Wien notes that slow growth in the U.S. economy "usually results in strong returns for high-yield bonds." Between 1991 and 1993, for example, gross domestic product grew at an annual average of only 2 percent, but high-yield bonds doubled in value. But Greg Peters of Morgan Stanley adds two warnings - first, don't go for very risky junk bonds and, second, all bets are off if the economy slips back into recession - though Wien doesn't think that will happen.

High-yield bonds are difficult for small investors to assess (Is the borrower on the brink of bankruptcy? Is there collateral behind the loans?), so mutual funds are the best way to buy them.

Bob Carlson - who edits the excellent Retirement Watch newsletter and also serves as chairman of the board of the Fairfax County retirement system, a $38 billion portfolio - makes Columbia High-Yield (CMHYX) his top choice in the category. Morningstar says the fund "has earned a stellar record with its focus on less-risky junk bonds" and awards Columbia five stars, the top rating. The fund's latest report shows that its portfolio is yielding about 8 percent, an impressive number given that the bonds carry an average maturity of only four to five years. Among the top holdings of manager Jeffrey Rippey, who has been running the fund since 1993, are bonds issued by Cott Beverages, Teekay Shipping, and Starwood Hotels and Resorts.

A second fund recommended by Carlson is Vanguard High-Yield Corporate (VWEHX), which also "takes much less risk than the competition." The fund, managed by Earl McEvoy for 18 years, yields about 9 percent currently. Its bonds - issued by firms such as Solectron, MGM Mirage and Waste Management - have longer maturities than Columbia's, but the portfolio is more diversified. McEvoy also wins five stars from Morningstar, but one advantage of his fund is its low Vanguardian expense ratio of 0.27 percent. Columbia charges 0.85 percent.

• Blue-chip stocks. Finally, if you are looking for yield, don't forget stocks. When share prices fall, yields for new investors rise. On Thursday, nine of the 30 stocks of the blue-chip Dow Jones industrial average were yielding 3 percent or more, including such stalwarts as Caterpillar Inc. (CAT), at 3.5 percent, and Philip Morris Cos. (MO), at 5.4 percent. If the economy deteriorates, it is possible that some high-yielding companies will have to cut their dividend payouts. For example, J.P. Morgan Chase & Co. (JPM) has been suffering lately from bad loans, and its stock price has dropped by half since March. If the prestigious financial firm can continue to pay its indicated dividend, the yield, based on Thursday's price, is a stunning 6.6 percent.

For the less adventurous, consider Procter & Gamble Co. (PG), whose stock, which has risen by one-quarter in the past two months, nevertheless yields 1.7 percent, only a little less than a two-year Treasury bond. Or check out Merck & Co. (MRK), the drug giant, at 3 percent, or International Paper Co. (IP), at 2.8 percent, or even Boeing Co. (BA), a timely stock with war perhaps imminent, at 1.8 percent.

Real estate investment trusts (REITs), which are companies that own portfolios of properties, have shown exceptional stability in recent years. Their yields are down lately but still average 7 percent. Utility stocks are riskier, partly because the Enron failure and the California debacle have put deregulation in doubt, but Goldman Sachs is recommending two solid utilities, Energy East Corp. (EAS), now yielding 4.8 percent, and Pinnacle West Corp. (PNW), 5.3 percent.

You don't have to abandon stocks to benefit from decent yields in this troubling time, when putting your dollar bills under the mattress is more profitable - literally - than putting them in Treasury bills.



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