Today, I’m going to take the same train of thought one step further, and show you how the pros extend equity-valuation strategies into the bond market. In doing so, we’ll discover new ways to collect cash-flows from a company, even when volatility threatens the integrity of the dividend. Afterwards, we’ll go even further to explore an asset class that combines the benefits of bonds and equities to create one of the most prevalent ‘super-securities’ of modern investing.
Let’s start by making a very simple assumption: dividend paying stocks are extremely expensive in the modern market, and systematic volatility is currently beyond the tolerance range of the personal investor. This isn’t too hard an assumption to make. Personally, I always find myself wishing that stocks would cost less, or that the markets would perform in a more predictable fashion.
However, the equity markets are by far the most transparent of all securities, and therefore allow us the best ability to understand the company and industry-specific (non-systemic) risks that we would like exposure to. While it is theoretically possible to apply this transparency towards creating a mathematically-diversified portfolio that completely negates all market risks, while ensuring that an idea purchase price is realized for each security involved, there’s an easier way for a less-sophisticated investor to secure their investment into a near mathematically perfect venture.
As I continue to mention throughout these periodicals, a short/medium term debt-security (ie. A bond) that is held until maturity is the perfect investment. The investor making the purchase knows exactly what income the coupons will produce, and can reasonably calculate any opportunity costs associated with undergoing such an investment. The absolute risks are then exclusively limited to that of default. As a bond investor that holds until maturity, you are either paid or you are not.
This simplifies analysis greatly, because all we really need to focus on when evaluating a company is a simple question of “will this company survive until the maturity date with enough liquidity to pay out its obligation to my portfolio?” It doesn’t matter if the value of the security goes up or down, because you’re already satisfied with the end returns that you will receive, making obscure momentum, volume, and arguably even macro-fundamental analysis secondary objectives. All you need to do is ask your investment advisor what would happen to this company in the event of an earth-shattering market melt-down, and you’ll have your answer.
The strategy sounds too easy, but the corporate bond market is so robust that it leaves plenty of opportunities available for even small retail investors. For some simple examples, head out to the yahoo bond center and see for yourself. Warren Buffet purchased a massive amount of debt from the Bank of America (BAC), effectively basing his decision on the same method I’ve described above. He decided that he was confident in BAC’s ability to remain solvent for the mid-term, and purchased an amount of debt from the company. While the nature of the Buffet transaction was a bit more complex than what everyday investors like us have available to us, the opportunity still persists.
The BAC stock currently pays out approximately $17.3 in dividends every year, for every $1000 that an investor purchases. Over an 8 year period, ignoring capital gains (because the volatility is simply beyond our ability to forecast as smaller investors) collecting this dividend would result in a net return for about $150. Alternatively, the comparable corporate bond pays our approximately $48 in coupons every year. Correcting for the current market price, the bond nets our hypothetical investor near $375 in returns by the end of the same 8 year period. What does this mean? It means that the investor was more than double the cash-flows of the investor that invested in the dividend stream.
In order to meet these returns, the stock would need to realize $1.55 in capital gains to match those returns, a full 22.6% return over its current market price. As personal investors, we simply aren’t equipped to forecast a bull-run of that size, on a stock as notoriously volatile as BAC. But we can collect the coupons, and reap the Buffet-Calibre rewards associated with the debt class.
I’ll throw in a bonus example for the ultra-conservative investors. Johnson and Johnson (JNJ) famously trades sideways as a staple component of the generic large-cap dividend-centric portfolio. Its consistently rising dividend is arguably the only real return that you will see over a mid-term horizon. If an investor purchases $1000 of this stock entirely for the dividend over a 6 year period, they will receive a little less than $250 in returns (entirely ignoring capital gains).
By purchasing the comparable bond, the investor receives $313 in coupon payments, and doesn`t need to worry about the high market risk associated with holding equities in today`s markets. In order to make up this sort of return, JNJ would need to grow by an (albeit fairly reasonable) 10%. However, if the market five years from now proves to be equally as treacherous as the one we face today, a risk adverse investor can immediately see the benefit of weathering the storm beneath an umbrella of debt.