On November 30th, the Government of Canada ten year bond had a yield of 2.15%. Not only is this low, or very low, it is the lowest yield in the 76 year history of this basic security. To put this into context, over that 76 years the average yield was 7%, and in only six other years has the yield been below 3%. But it gets worse. For a bond investor, whose chief enemy is inflation, the more important question is the real return of the bond; that is, the yield after inflation. Inflation in Canada was running at 2.9% at the last reading, meaning that a buyer of the 10 year Canada bond has a negative real return of .75%. Only twice before has the real yield on the ten year bond dipped into negative territory, and that was during the high inflation years of 1974 and 1975 when interest rates of 9% were not enough to produce a positive return.
Yields on bonds go down when the bond price goes up, and the price of a bond (like everything else) goes up when more investors want to buy it than sell it. Sometimes there are so many more buyers than sellers that prices rise to “bubble” levels. We have seen the same thing in house prices, and periodically in stock prices. There is no reason to think that we are not now seeing it in the prices for long bonds. As much as we would like to believe that the financial markets are dominated by clear thinking rationalists with ice water in their veins, the truth is otherwise. Emotion frequently gains the upper hand over reason in the short term. As Alan Greenspan, former Chairman of the Federal Reserve Bank famously commented about the stock market “irrational exuberance has unduly escalated asset values”. In this case, of course, it is not so much irrational exuberance as irrational fear.
It is a basic fact of the news business that fear and disaster sell, or as the old dictum goes, “if it bleeds, it leads”. When the TSX Index fell 332 points on November 9th, it was front page news in all the papers. On November 30th, when it rose 471 points, the biggest one day increase in 32 months, only those who made it to page B17 of the Globe and Mail Report on Business got to read about it, buried in the headline story about the mistake of getting fooled by short term market gains. Bombardment by intensely negative news over a long period of time cannot help but have an effect on the emotions of investors. Whether the news is true, false or as is usually the case, partly true, becomes unimportant. Investors move in herds, and sometimes the herd stampedes.
We are not inclined to minimize the problems facing the world economy in general and Europe in particular. The strains of high government deficits and high levels of sovereign debt are real, and if unaddressed, have the potential to do real harm. Yet, these problems are no different in kind than they were last month, last year and in fact for more than a few years. Moreover, they are being addressed, although neither so quickly nor as fully as we would like in an ideal world. What is chiefly different is the intensity of the spotlight being focused on areas which were heretofore of importance mostly to central bankers and the Ministers of Finance of indebted countries. Is this an unlooked for side-effect of the U.S. debt ceiling debate of last summer, which brought the subject of unsustainable debt to the forefront, or of the single minded insistence of the U.S. Republican party that spending cuts are the only solution to the debt woes of America? Is this why a financial world which was largely unconcerned about Greek debt problems and Italian bond yields can now talk of little else? It is impossible to know the cause, but it is easy to measure the effect.
Fearful investors sell stocks and buy bonds. Even though they realize that bonds are unrewarding, bonds offer the illusion of safety – illusion, because inflation is now surpassing the paltry yields even on the longer, higher yielding bonds. Stocks, in contrast, are seen as risky. They go up and down unpredictably, and often by large amounts. But there is another aspect of stocks which many investors fail to value as highly as they should.
Good quality stocks pay dividends, and very good stocks increase their dividends on a regular basis. During the dire days of late 2008 and 2009, only two companies in our portfolio dropped their dividends but eighteen raised them. Dividends tend to be steady because companies hate the bad publicity that comes with a dividend cut. While they are not guaranteed, they are very reliable. Some of our portfolio companies have raised their dividends every year for decades.
At the moment, a purchaser of the entire TSX Index receives a dividend yield of 2.77%. This is the second highest dividend yield in the past twenty years. Usually the dividend yield is far less than the interest rate on the ten year Canada bond. In fact, over the past sixty years the dividend yield has on average been about 46% of the ten year interest rate. Between 1960 and 2007, a period of 47 years, the dividend yield never rose above 70% of the 10 year interest rate. Today it is at 129%, an unprecedented development. Dividends have never been more attractive, compared to interest rates, than they are today.
Clearly this situation cannot last forever. There are three things that can make it change. In the first case, lots of companies could suddenly cut their dividends. If every dividend payer on the TSX cut its dividend in half tomorrow, the dividend yield would fall to 1.39% and the dividend yield would be 46% of the 10 year bond interest rate, a normal level. This is not going to happen. It is virtually certain that the value of dividends paid by the TSX companies will rise rather than fall this year, as it does virtually every year.
Secondly, the interest rate on the 10 year bond could rise. If it goes up to 6%, the dividend yield would fall to the normal level of 46% of the interest rate. We think this will happen, but not overnight. However, it points out the extreme danger in buying bonds with long maturities. If the interest rate on the 10 year bond does rise to 6% within two years, present owners will suffer a capital loss of about 24%.
Finally, the stock market could go up. If the TSX index rises from the present level of about 12,200 to 14,000, a level last reached in February, 2011, the dividend yield would fall to 2.41%. This would still be 112% of the 10 year bond yield, and would continue to be a high yield on an absolute basis. We believe that based on the earnings we have seen in the last financial quarter, 14,000 is a very reasonable level for the TSX, and we would not be surprised to see it reach this mark by the end of 2012.
As value investors, we believe that sometimes the market gets it wrong. We believe that the bond market is very wrong to offer yields so low on bonds with such long maturities. History tells us so. We believe that the stock market is wrong to price stocks so cheaply that they pay dividends at such a high yield level. History tells us that too. Putting these two ideas together produces a compelling case to buy only bonds of short maturities, and to buy quality stocks with rising dividends. Over time prices revert to the long term average. This means higher interest rates on bonds, and higher stock prices for quality companies.