What California Bonds and Ford Bonds Have in CommonLet's take a hard look at prices and risk in today's bond and stock markets. I'll start with bonds. Today you can buy a tax-exempt bond issued by the California Department of Water Resources that yields 4.82%. That's a pretty tempting rate on a bond that matures in 2008, if you've noticed that the 10-year Treasury note is yielding just 3.7% or so at the moment. It's even more tempting if you live in the high-tax state of California and can take full advantage of the bond's exemption from state taxes. So it's not really surprising that the price of this bond has increased 14% since it was issued just this month. In other words, a bond that originally yielded 5.5% and sold for $10,000 not so long ago, today costs $11,412 and pays just 4.82%.
Bond Buyers go out on a LimbI'd argue that in both of these cases investors are taking on more risk than they're getting paid for. For example, California faces a $38.2 billion budget gap over the next 14 months. That's up from an estimated gap of $35.6 billion just last January. So far the governor and legislature have been able to agree on just $14 billion in proposed spending cuts. And after seeing his original plan to raise taxes to fill the gap drown in a sea of bipartisan opposition, Gov. Davis has proposed a sleight-of-hand budget that relies on such "hidden" taxes as a $4.2 billion increase in car registration fees and issuing another $11 billion in bonds to be paid off over the next five to seven years by a half-penny increase in the sales tax. Ford, for its part, was told not so long ago that bond buyers wouldn't buy any more unsecured debt because the company as a whole was too financially shaky. The Ford Motor Credit bonds are secured by car loans. Such secured bonds carry the risk that more borrowers than expected won't make their installment payments. So why are bond investors willing to take on a high degree of risk for a relatively modest reward? Because the current policies of the Federal Reserve have, bond buyers believe, guaranteed them against the risks in these bonds. The bond market is interpreting the Fed's May 6 warning on the dangers of deflation as a commitment from Alan Greenspan and company to keep rates low for the foreseeable future. That means no interest rate increases even if the danger of potential inflation increases. The possibility that the Fed would raise interest rates to stage a pre-emptive strike at inflation before it even actually appears is off the table, bond investors believe. And with the Federal Reserve promising to keep rates low and to keep goosing the money supply until the economy rebounds, the odds that either California or Ford will default on their obligations is insignificant. At least that's what the prices of these bonds say that the market believes.
Looking at LucentYou can find the same kind of thinking about risk over on the stock side of the financial markets. Look at Lucent Technologies ( LU) for example. The shares are up a huge 88% to date in 2003 and an amazing 59% in the last month. The only question in investors' minds seems to be: When will telecom spending pick up? Lucent's recent quarterly report showed profit running ahead of projections. The wireless division, potentially the restructured company's strongest unit, showed margins of 17%. With the Fed promising to lower rates again and expand the money supply to increase growth in the economy, the market seems to feel confident that the company is on the road to a successful recovery. All this ignores the financial risks at the company. Another $300 million in cash flowed out the door in the most recent quarter, and if you read the company's 10Q filed with the Securities & Exchange Commission carefully, you'll note that Lucent now projects cash flow to slip by another $200 million or so in 2003, thanks to problems with the off-balance-sheet special trust the company set up to sell off vendor financing loans and receivables. The rise in the stock also doesn't seem to reflect the huge off-balance-sheet liabilities represented by the company's pension plan. The company is carrying about $5 billion in retirement benefit costs on its books currently, and that's possibly as much as $5 billion too low. And finally, there's the dilution that existing shareholders still face if the company is successful at paying off the convertible debt that could trigger a cash flow crisis at the company. Lucent has so far bought back about $1.6 billion of that debt at a cost of about 600 million shares. Those purchases have diluted existing shareholders by about 18%. But the company has another $2.1 billion in convertible debt still out there. With the increase in the value of Lucent shares, buying that debt will result in at least another 14% dilution. And add in the projected 6% to 10% dilution that will result when Lucent issues shares to settle its class-action lawsuit with shareholders, and the stock faces a stiff uphill climb.