“Perhaps it is time to replace the cult of the equity with the cult of the corporate bond,” says Citigroup. The S&P 500 has now suffered two “50% bear markets” in just six years (see chart below). The market has roughly halved since October 2007, whereas over the same period Citigroup’s Broad Investment Grade (BIG) corporate bond index has fallen only 5%. Yet corporate bonds remain cheaper compared to US government bonds (Treasuries) than at any point since the 1930s. So it’s hardly surprising they are becoming the “risk assets of choice”. But should you really dump all your blue chips and pile into individual bonds?
What’s best – shares or bonds?
Corporate bonds certainly look cheap compared with blue-chip equities. They are more secure, ranking higher for repayment of capital in the event of default. What’s more, a typical investment-grade corporate bond offers a higher yield than a typical S&P 500 equity. The S&P 500 currently only yields a sickly 3% against a 90-year average of 4%. So set against shares, corporate bonds look compelling. But pitch shares against government, rather than corporate, bonds and they also look good value. Before 1960, says Citigroup, equities offered a dividend yield 2.16% above the government bond yield. But after 1960, “when the cult of equity really took hold”, US shares yielded on average 3.57% less than government bonds as investors piled in and pushed up share prices. But last November “reversed 50 years of market precedent” as investors dumped shares and left the S&P 500 offering a higher average dividend yield than a typical ten-year Treasury. That’s still true even after the 20% decline in dividends since then. So over a 50-year time horizon, shares look cheap.
This matters because, in the right climate, they can offer thumping returns. For example, the long-term yield on corporate bonds is a respectable 7%. But hold high-yield shares between, say, 1980 and 2000 (and re-invest dividends), and you would have multiplied your starting capital 23 times, according to the Barclays Equity Gilts Study. And as Rob Arnott of US group Research Affiliates notes, although bonds are currently good value and shares have performed appallingly lately, since 1802 equities have beaten bonds by about 2.5% a year. But that’s not the only reason to pause before dumping your shares for corporate bonds.
The liquidity trap
Buying and selling even large quantities of most shares is no problem. But that’s often not true of bonds. Take index sizes. The MSCI World Equity Index may have fallen over 50% since October 2007, but is still valued at $15.6trn. Meanwhile the Citigroup BIG index weighs in at just $3.2trn. Sure, the issue of $730bn of new investment-grade corporate debt so far this year (compared with just $50bn raised via new share issues) has helped. But the small market size means brokers dealing with retail investors usually restrict the bonds they will offer and often impose minimum deal sizes. And it can be hard to decide what to buy. General Electric, for example, has issued 85 tranches of corporate bonds with varying yields, maturities and features. By contrast, most firms list just one type of share.
There are also regional restrictions. Stockmarket investors can get access to all of the world’s major economic blocs from the US to Asia, and even Africa. That’s not true for corporate bonds. The BIG corporate bonds index, for example, has a 51% weighting towards America and no exposure to Asia or emerging markets generally. So “making a meaningful switch from equities into corporate bonds is not a realistic option” in many emerging markets, says Citigroup. Unsurprisingly, corporate bond indices are also heavily weighted towards sectors where companies tend to be highly indebted, such as financials, telecoms and utilities stocks. It can also be difficult to get exposure to sectors such as health care or energy, where firms have more robust balance sheets and therefore less need for debt – somewhat undermining the ‘flight to safety’ argument for corporate bonds.
What to do
We’re not saying you should avoid corporate bonds – far from it. But we’d rather have the best of both worlds. To get round the hassles that come with buying individual bonds, we would go for a managed fund with low exposure to financials, such as the M&G Corporate Bonds Fund, or the Invesco Perpetual Corporate Bonds Fund. But don’t sell your best shares to fund them. Several stocks offer a forecast dividend yield above the redemption yield on their bonds. Citigroup also looks for dividend cover above 1.5 times and an S&P credit rating of at least A-. Firms that cut the mustard include pharma giants GlaxoSmithKline (LSE:GSK) and Pfizer (NYSE:PFE), as well as household goods group Unilever (LSE:ULVR) and telecoms giant Telefonica (NYSE:TEF).