Friday, August 18, 2006

Bonds Vs Equity

Was having discussion with my friend on how he views bonds Vs equity
my friends take
“I view bonds as an inferior way of allocating my capital. They don't have a lot of upside ( no incremental earnings, due to their very fixed nature ) and a lot of downside ( they are totally dependent on the business in question being able to keep it's promises )

On the other hand, if we invest in high grade equity bought at a bargain price, we stand to atleast eliminate the upside opportunity costs to some extent. The downside depends in both cases, on the extent and rigour of our analysis of the company.

Now, if we compare stocks and bonds of the same company, if our analysis And logic are solid, devoid of any prejudices, we stand to eliminate the distinction between stocks and bonds as such. An equity holding would translate into almost bond status because of the assurance of no erosion in value and a large upside.

As always, my two doubts are dependent on a lot of externalities which I cannot possibly explain in just a single mail.”

To which I replied

Actually sent him a summary of an excellent article I had read earlier

Investors should buy the common shares and sell short the bonds of companies where the equity yield is higher than the inflation-adjusted (real) bond yield, provided the dividend is secure.

Four reasons to pursue this strategy:

(1) dividends will likely rise faster than inflation providing investors with a higher real return,
(2) equity provides greater capital appreciation potential than debt,
(3) Treasury yields are expected to rise in 2005, (Yr 2005 specific)
(4) corporate spreads are unlikely to narrow from current levels, (Yr 2005 specific)


Dividend yield higher than real debt yield does not make economic sense. An asset with higher growth potential theoretically should offer less current yield than a similar asset with lower growth potential.
The average difference between investment grade corporate debt real yield and the S&P 500 dividend yield has been 480 basis points since 1994. If the dividend yield is higher than the real bond yield for a particular company, investors would seem to be expecting a dividend cut.

However, if the dividend is secure, the yield differential should adjust over time through the shares appreciating (dividend yield falls) or bond price erosion (yield rises). This adjustment can come from one or both sides.

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