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SKARBECK: Investors may miss mark by switching to bonds

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Ken Skarbeck InvestingInvestors are abandoning stock mutual funds. Money has flowed out of stock funds in 10 out of the past 17 months. Much of it is going into bond funds, with some $185 billion shoveled in so far through July in 2010—the most on record since 1984 when the data was first measured, according to the Investment Company Institute.

The stampede of money into bonds has caused bond prices to rise and rates to fall. According to one source, the average investment-grade bond is priced more than 110 cents on the dollar. Such bonds have performed well, with investment-grade corporate bonds returning 7.1 percent this year.

Corporations are rushing to market with new bond issues to take advantage of the record-low borrowing costs to either refinance their existing higher-cost debt or put funds to work in other activities.

The top 10 lowest-yielding corporate new issues in history have been sold in the last 14 months.

A week ago, Johnson & Johnson sold $550 million of 10-year bonds with a 2.95-percent yield, the lowest corporate rate ever paid on 10-year debt.

The investor frenzy comes at a time when the yield on a 10-year Treasury bond is a record low 2.6 percent. Back in the early 1980s, 10-year Treasuries yielded more than 15 percent, so this has been one huge bond bull market spanning 30 years (granted, with plenty of zigzags along the way). So, why, late in the tooth of a bull market, do we see investors committing record sums to bonds?

This flight to safety in what are perceived as low-risk investments is taking place for a number of reasons: the poor performance of equity mutual funds in general over the past several years, a heightened aversion to risk following the 2008-2009 credit crisis, and, perhaps, fear of deflation. Bond investors today would prosper if the United States fell into deflation.

Mohamed El-Arian, one of the gurus at fixed-income giant PIMCO, doesn’t forecast deflation as a “baseline scenario,” but nevertheless he puts the chance of its occurring at 25 percent.

However, countering the deflation argument is the commodity market. Wheat prices recently hit a two-year high, and other agricultural commodities remain above their historic lows. Gold and other metal commodities continue to hover at high levels. And, in recent news, why would BHP Billiton be offering $39 billion for the fertilizer company Potash if it believed food-price deflation was in our future?

Instead, it seems more likely that bond investors today are making the same mistake stock investors made back at the peak of the stock-market bubble. Their behavior is reminiscent of the first quarter of 2000, when investors sent a record $130 billion into stock mutual funds, right before stock prices sank.

In contrast to low-yielding bonds, investors really don’t have to look too hard to find quality U.S. companies with P/E ratios of 12 or less, and with dividend yields around 3 percent. Take the inverse of a 12 P/E (or 1 divided by 12) to obtain an earnings yield of 8.3 percent. This means the company is generating in excess of an 8-percent earnings return on the price investors are paying to acquire the shares.

Eventually, the stock market will reward investors at these prices. In the meantime, you cash dividend checks.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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