Below I have provided our response to this article.
You make some good points and the overall concept is good. However, it is important to separate out the type of risk you are discussing. Treasuries or for that matter any developed country government bond is significantly different from any corporate bond. Granted Government bonds are not completely riskless, but they for good reasons are the safest secured investments. Fiat is a big factor and defaults are rare while failure to pay is unheard of in developed market countries. There is a big difference between an act of default, restructuring, default and “dead”.
Emerging markets are not much different and if memory is correct Russia was one of the largest “failures to pay” in recent memory – 1916 and 1998. Then there was the Latin Contagion of ’01-’02 where Argentina defaulted but restructured its $82 billion of debt.
Swapping credit paper or anything less than direct federal debt changes the nature of risk. Agency paper followed by government guaranteed debt are less risky than corporate paper but a careful read of the indentures/covenants is important to understand what is guaranteed, how it is guaranteed and what is a default. Once you move to corporate debt, the gloves come off and this is a completely different game.
Where you stand in the capital structure with corporate debt (aka secured – priority of claim to assets), maturity/term (equities are not termed - no maturity) and what constitutes a default is critical to the safety of principal. I am still surprised when I see a default headed to the creditors and a non-debt obligator appears ahead of the debt holders. A truly painful event in investing is receiving notice that there are obligations ahead of the debt holders that get priority on the liquidated assets. Especially when there is a restructuring and you are left holding some pretty paper that is pretty worthless.
My research on credit paper indicated that there is a price point or range where debt prices begin to emulate equity pricing. Although I do not have the data handy, I seem to remember the results clearly showing that as the issuer becomes more embattled and their bond pricing declines the volatility and price movements of the debt begin to align with the stock price (in terms of correlation moving toward 1.0). If I remember correctly it begin with bond prices moving to somewhere about 60% less than par and kicks in fully around 40% of par. In other words when bond prices decline from $1,000/bond to $600/bond then fully reflecting equity at about $400/bond. Junk status is awarded somewhere in these ranges. I believe that this is an inverse relationship to the old convertible bonds.
As far as purchasing power, I find the argument a difficult one to defend with yields and inflation. As with Japan in their “lost decade”, we may be in a disinflationary environment. As the value of money increases (ie: the ability to buy more goods tomorrow with today’s money) the pricing spiral increases. The result is money held at any rate equal to or more than the rate of disinflation allows a foothold to an increase in purchasing power. If we are truly in a disinflation environment, then the current yields are justified even if they are not desirable. Preservation of wealth is good as long as you can keep the money safe.
The argument for yield is problematic at best because the absolute level of yields is not as critical as the relative level. The best example is Latin America in the late 1990’s where yields in some places were 30.0%+. I had clients demanding to invest there because their friends were making “so much money”. True enough, however, the currency was declining at a rate greater than 30% per annum and domestic inflation in these countries was not too good either. The absolute basis point value of the yield is also important. Any increase in yields is problematic but inevitable. However, this is compounded geometrically when yields are so low. Duration management is critical and a two edged sword. Ibbotson and Sinquefield efficient frontier studies seem to be more important today than ever.
As far as dividend stocks go, we made the transformation you endorse several years ago when we got the permission from our clients. In order to justify a move to dividend stocks we put rules into place and have kept to them. Primarily we must use protective strategies for nearly every dividend stock we buy. This “synthetic income” approach has its risks especially when looking at credit structure. We keep everything short term and employ more caution than when buying corporate bonds. Our approach involves buying quality stable stocks and selling calls to enhance yield, reduce cost basis and prevent ourselves from becoming overly ambitious. The approach has worked well and the results have been acceptable to us and more importantly to our clients. You can check out our work at: AddingAlpha.Blogspot.com
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