Kass: Choosing Bonds Over Equities

This blog post originally appeared on RealMoney Silver on Jan. 26 at 8:05 a.m. EST.

The chief problem of this work has been one of perspective -- to blend the divergent experiences of the recent and the remoter past into a synthesis which will stand the test of the ever enigmatic future. While we were writing, we had to combat a wide-spread conviction that financial debacle was to be the permanent order; as we publish, we already see resurgent the age-old frailty of the investor -- that his money burns a hole in his pocket. But it is the conservative investor who will need most of all to be reminded constantly of the lessons of 1931-1933 and of previous collapses. For what we shall call fixed-value investments can be soundly chosen only if they are approached -- in the Spinozan phrase "from the viewpoint of calamity." In dealing with other types of security commitments, we have striven throughout to guard the student against overemphasis upon the superficial and the temporary. Twenty years of varied experience in Wall Street have taught the senior author that this overemphasis is at once the delusion and the nemesis of the world of finance.

-- Benjamin Graham and David Dodd, preface to the first edition of Security Analysis (May 1934)

Whether bonds or stocks, an investment vehicle is attractive only if it is priced attractively relative to risk and to the future stream of profits.

I believe that, in the fullness of time, the government's massive stimulus should take hold and equities will once again have their place in the sun, but the indigestion caused by extreme credit expansion will be with us for an indefinite period of time. Given the last decade's abuses, we have to recognize that even a favorable outcome will result in more muted growth than most are accustomed to. Navigating the period directly ahead of us will be a challenge for corporate and investment managers given the magnitude of the financial crisis and the absence of a historic road map for success or strategy.

The broad list of uncertainties, coupled with the likelihood of a protracted period of weak economic growth, suppressed interest rates, deflated and volatile corporate profits, and rising equity investor apathy and disinterest, will translate to selected fixed-income investments growing in appeal as they may provide equity-like returns with substantially less risk than would be incurred in the stock market.

Indeed, debt may be now cheaper than equities on a risk/reward basis.

It is important to note that, regardless of the strength and soundness of the obligor enterprise, on a structural basis, debt is a senior obligation to equities. Debt securities hold a senior claim on assets, with the promise of a specific and contracted return of interest and a promise for the eventual repayment of principal. By contrast, equities provide for an unlimited participation in the profits of a company after the debt payments have been made.