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.
There's an old story about a group of blind men walking down the road in India who come upon the elephant. Each one touches a different part of the elephant -- the trunk, the leg, the tail or the ear -- and come up with a different explanation of what he'd encountered based on the small part to which he was exposed. We are those blind men. Even if we have a good understanding of the events we witness, we don't easily gain the overall view needed to put them together. Up to the time we see the whole in action, our knowledge is limited to the parts we've touched.-- Howard Marks, Oaktree Capital Management ("The Long View," January 2009)
Like the three blind men, most investors failed to see the signs during 2006-2008 that led to the depression in the world's stock markets and the vulnerability to our financial system. Worse yet, many in the media and in academia heralded the notion of overweighting stocks vs. bonds for the "long run." At Wharton (my alma mater),
made the audacious claim that stocks were less risky than bonds, and elsewhere, during the later innings of the tech bubble in the late 1990s,
opined that the the
would advance to 36,000.
Siegel and Glassman clearly didn't see the developing investment mosaic and the big picture; instead, they focused on the elephant's tail and ear.
We have almost certainly witnessed the end of a long-term secular trend that dramatically favored equities over bonds and served to promote money managers as financial icons.
In the 25-year period ending 2000, the
only occasionally declined but never by more than 8% in any one year. Amazingly, 16 of the 25 years yielded annual returns in excess of 15%. No wonder investors became dip buyers.
Nevertheless, the last decade has been lost.
The same is true for credit. Leverage has now become a four-letter word. The bull market in tolerance has ended with a bang as there is no longer willingness on the part of lenders (especially of a mortgage kind) to accept un- and non-documented borrowers any more, no longer is the unregulated shadow banking system expanding its role, and the financial weapons of mass destruction (read: derivative products), which were the kerosene to economic/credit growth, are worth a fraction of what they were sold for.
Household wealth and corporations' profitability now are stressed.
Over the past 12 months, credit developments have taken a toll on household wealth (home prices and stock prices) and have wreaked havoc with corporate profit forecasts. Remember that profitability only recently hit a 53-year-old record in 2007; there is a long way back to a mean regression of corporate profit margins.
In modern financial history, equities have typically provided dividend yields less than U.S government bonds because stocks gave investors uncapped participation to the upside of growth. For the first time since the mid 1950s, however, stock dividend yields exceed government bond yields, perhaps, in part, reflecting the increased economic challenges (and quantitative easing) and the emergence of a new era of frugality and savings.
Regardless of one's view of equities, selected fixed-income vehicles (particularly in the mortgage, high-yield, bank loan, corporate and convertible markets) are pricing in an economic outcome worse than that experienced during the Great Depression. There are several obvious reasons why the debt is priced improperly relative to reward, including a worsening credit cycle and the broad effect of hedge and mutual fund redemptions in dampening a wide array of fixed-income prices.
At this point in time, I would prefer to invest in debt, an investment class that is senior to equities. The current yield opportunities and prospects for capital appreciation appear to provide a far better risk/reward for both individuals and institutions.
What follows are good examples of some opportunities I see. Quite frankly, your broker or financial planner will not likely steer you to these product offerings as they provide virtually no commission to them, but you might be better served by considering your interests above your broker's interest.
In my new long/short partnership, I am cherry picking my investments in the higher-yield arena. In particular, I am finding a number of attractive convertible bonds with put-able features that provide outsized yields to put. This approach is not for everyone; it requires a lot of research, and it is a too-concentrated approach for most.
Instead, most individual investors are better off with tax-efficient, diversified products that are liquid and involve modest transactional fees and that are no load and have low expense ratios.
As you can see, many of these products are readily available to the individual investor at the
family of funds. (
is good, too.) I have listed some ideas, starting with the most conservative and on down to the most aggressive vehicle.
- Vanguard Intermediate-Term Tax-Exempt Fund Investor Shares (VWITX) - Get Report. This is a diversified $19.5 billion tax-exempt fund that holds almost 1,700 tax-exempt bonds, with an average maturity of 7.3 years. Over 80% of the holdings are rated AA or AAA. The portfolio yields approximately 3.5% (untaxed); that's nearly a 6.0% pretax-equivalent yield for a New York state resident paying the highest marginal tax rate of 42.93%. The minimum investment is $3,000.
For individuals' non-taxable accounts (IRA, 401k, etc.) and institutions:
- Vanguard Intermediate-Term Investment-Grade Fund Investor Shares (VFICX) - Get Report. This is a diversified $7 billion high-quality investment-grade bond with an average maturity of 6.3 years. The portfolio yields about 6.15%, and the minimum investment is $3,000.
- Vanguard Convertible Securities Fund (VCVSX) . This is a diversified convertible bond portfolio totaling $900 million, managed under the auspices of the capable Oaktree Capital Management. The portfolio consists of 13 stocks and 155 bonds, its average duration is 3.7 years, and the current yield is 4.95%. The minimum investment is $10,000.
- Vanguard High-Yield Corporate Fund Investor Shares (VWEHX) - Get Report. This is a diversified $7 billion fund consisting of about 250 bonds. The current yield on the fund, outsourced to Boston-based Wellington Management Company -- I have recently met with one of its principal portfolio managers -- is 11.39%. Its average maturity is 6.2 years, and the minimum investment is $3,000.
In summary, we are in uncertain economic times and investors should err on the side of conservatism.
Mr. Market has had a massive heart attack, and it will take a while for him to recuperate. A broad trading range and base-building remains my baseline expectation.
Not only do investors have a senior claim relative to equity, but investing in a diversified portfolio of fixed-income investments could now exceed the long-term return of equities, without equity risk.
Doug Kass writes daily for
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Know What You Own:
Doug Kass highlights some bond funds in the Vanguard family of funds, and some of the other bond funds under the Vanguard umbrella include the
Vanguard Total Bond Market Index Fund Investor Shares
Vanguard Long-Term Bond Index Fund
Vanguard High-Yield Tax-Exempt Fund Investor Shares
. For more on the value of knowing what you own, visit TheStreet.com's
At the time of publication, Kass and/or his funds had no positions in the funds mentioned, although holdings can change at any time.
Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Long/Short LP.