These Assets Haven’t Been This Cheap Since 1932

Stocks are pricing in a recession, and bonds are priced for a depression.”

That’s what Bill Gross, Managing Director of PIMCO and the world’s “Bond King,” has been telling anyone who would listen for months now.

Stocks are cheap, but bonds are at irresistibly cheap levels. If you’re looking to buy low, sell high and collect 9% or 10% interest in between, corporate bonds are definitely worth a look right now.

The past year has been painful. Two million jobs have been lost, trillions of dollars in paper wealth has evaporated, the U.S. dollar is just off multi-year highs (showing its first signs of cracking though), and hurting exports…I could go on and on.

No one knows how bad it’s going to get for the U.S. economy. Or how long it’s going to last. As we looked at over the weekend, many of the leading economists and money managers predict 2009 to be, at best, a long recession and a slow recovery.

At this point, the markets have priced in most of the bad news.

We’re in a recession. Prices are falling, demand is falling, and earnings have already started to fall. Lower profits mean lower share prices. We all know it…the stock market knows it. Stocks have fallen back to 1998 price levels, erased a decade of gains, and look cheap.

Corporate bonds, however, are a completely different story. Corporate bonds, relative to government bonds, are cheaper than they’ve been in more than 70 years!

It’s all due to how investors look at bonds. In the bond market, earnings per share, P/E ratios, growth rates, and analyst estimates just don’t matter. All that matters is, “Can this company make good on this loan?”

That’s it. Bondholders just want their money back plus interest. All the other stuff, which drives share prices up and down, really doesn’t matter. (Note: the derivatives market has made it a bit more complicated, but it’s still basic borrowing and lending money at the core).

Recession or Depression

That’s why the most important consideration when it comes to owning a diverse bond portfolio (which you probably own if you own any investment-grade corporate bond funds) is the state of the overall economy.

In a recession, top-tier companies which generate loads of free cash flow (think Wal-Mart, DuPont, Johnson & Johnson, etc.) aren’t going anywhere. Revenues, margins, and profits will get squeezed a bit, but they’ll be around to pay the bills.

That’s all a bondholder really cares about. As a result, they have “investment grade” debt. There’s very little risk of them not being able to repay their debts, even when we know there will be more bankruptcies, mass layoffs, and corporate belt-tightening.

That’s why Gross says in his December note to investors, “[It’s] better to own corporate bonds than corporate stocks.” It’s because you get paid first.

Bonds are Best in Bad Times

At the end of the day, investing is all about risks and rewards. Every investment carries some element of risk. Even “risk free” U.S. government bonds are at risk of inflation and default (a long shot, but seemingly more possible by the day).

Corporate bonds are no different. And before buying a bond, stock, or real estate, you have to ask, “Does the rewards of bonds outweigh the risks?”

During good times, the answer is usually “No.”

When the economy is rolling along, credit is flowing freely, and anyone can get a loan at a pretty good rate. In this case the risks might be lower, but the rewards are much, much lower. The risk/reward situation is against you.

During rough times, the risk/reward situation gets flipped around.

When no one else is willing to lend (which is basically what buying bonds is like), you can get paid a much higher interest rate. There are a lot of borrowers, not many lenders, and you can get a very high reward (much higher interest rates) for your risk.

That’s what is going on with the bond market right now. The risks are a good bit higher, but the rewards are much, much higher than usual.

Mind the Gap

Since the credit crisis hit this summer, pools of capital for lending have dried up. When the government talks about frozen credit markets, this is what they’re talking about.

Banks have labeled most companies “too risky.” As a result, the banks won’t make the loan. Instead, they’ll turn and lend to the government by buying less risky U.S. government debt.

This is killing off some businesses, cutting deeply into the profits of others, and creating opportunities for others.

Treasury BondsTake a look at the chart to the right. The yield from U.S. Treasury bonds has plummeted. Currently a 10- year Treasury bond yields a measly 2.5%. Meanwhile, the average yield on an investment-grade corporate bond (like Wal-Mart, DuPont, etc.) is 9%.

That makes the yield spread (the gap between corporate bonds and government bonds) between 6% or 7%. Compare that to 2006 and 2007 and the spread between yields on government and corporate debt was only 2%. Now, it’s 6% or 7%. It’s an absolutely staggering increase.

John Lonski, an economist at debt rating firm Moody’s, says, “The yield spread…still exceeds each of its previous monthly averages going back to 1932 despite how the current recession hardly resembles the slump of the early 1930s.”

That’s how bad it has gotten in the bond market. And it’s a big reason why I think high-quality corporate bonds are worth a look.

From here, either high-grade corporate bonds are absurdly cheap or the world economy, as we know it, is coming to an end.

Stick to the Plan

I’d bet corporate bonds are cheap because, so far, everything is working the way it’s supposed to during a recession.

Take a look around you. Demand is falling for everything. Consumers and businesses have started saving for rougher times ahead. Businesses are selling down inventories. Businesses which lost their competitive edge, failed to adapt, or loaded up on debt to eke out slightly bigger profit margins, are closing up shop (i.e. newspapers, overleveraged REITs, retailers).

That’s what is supposed to happen. It’s not supposed to be fun. It’s a part of purging the excess out of the system.

Even though we go through this purging and resetting period every few years (granted to a varying degrees – recessions are never exactly the same) stocks nosedive, panic sets in, and tremendous values are created for investors willing to take the risk.

That’s why I turn to people who have been at this successfully for a long time. One of those is David Dreman. Dreman is the chairman of Dreman Value Management and in October of 2007, while warning of the impending market collapse, offered this sage advice:

Since coming to Wall Street in the late 1960s, I have been through seven such crises. Somehow, the market survived them and thrived…

During each crisis investors felt confused, uncertain and panicky. They believed nothing in their previous experience could help them cope with the ominous new world they faced. “Sell, sell, sell,” their inner worrywarts advised. “Save your capital before it’s too late.”

This almost always turned out to be a bad move. Selling in a crisis is foolish.

There you have it: Uncertain…panicky… foolish. Three words which describe average investors right now.

Of course, the average investor buys and sells at the worst times and consistently loses money. So it’s best to do the exact opposite.

I realize, volatility is high and it’s going to stay that way for awhile. There’s a lot of uncertainty (OPEC, oil prices, Fed rate cuts, etc.), but there are still opportunities for those willing to look for them.

The best thing to do now is to get a plan together and stick to it. At depression-level prices, corporate bonds should be a part of any plan and there couldn’t be a better time than now to start buying.

There are a lot of advantages to boring old bonds which tend to get thrown to the wayside when the Dow is setting new all-time highs. Corporate bonds provide a very steady stream of income which is now (and will continue to be) heavily valued in today’s market. Bonds can boost your retirement income, provide a safe haven where you earn safe and steady 8% annual returns, and provide you with some extra cash flow so you’re able to buy more stocks when the market drops.

That’s why now, with corporate bond yields at 70 year highs relative to government bonds, you should reserve a spot in your portfolio for them and fill it over the coming year or so. And if inflation fears really get out of control, there will be an even better time to buy coming soon.

In a market like this, when emotions are running wild, there’s no better way to avoid the pitfalls of fear (selling when the market is dropping) and greed (jumping in late fearing you’re missing the big rally) than patiently waiting. There is a historically proven conservative investing strategy that will help you to rebuild your portfolio.

It’s a buyer’s market and you get to set the price you’re willing to pay. Whether its stocks, bonds, real estate, or anything else, if you wait for the price to come to you, chances are you’ll probably get it. So as always, it’s time to buy, but it very well could be time to buy for another two years so buy smartly and sparingly.

By Andrew Mickey

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