Week 181 - Bond Substitutes

Situation: Our long-term investment philosophy balances the risks of stock ownership by hedging those purchases with bonds, bond substitutes, or non-correlated assets. The idea is to have an investment that is capable of ameliorating a 20+% drop in the S&P 500 Index. Otherwise, it could take 2-6 yrs for your retirement portfolio to recover from a Bear Market. If you’re over 50, that doesn’t leave enough time for you to make up for the loss and still have an adequate retirement income. The best hedges are US Treasuries because those go up a lot in price when stock prices plunge. However, most retail investors currently avoid US Treasuries. Why? Because their interest rate is likely to remain low while the Federal Reserve cautiously emerges from “financial repression” (see Week 76 and Week 79). Financial Repression will probably remain with us as long as world debt is more than twice world GDP, and that is currently at a record high of 212%. This means that you need to learn about other ways to protect your retirement portfolio, starting with bond substitutes.

Conservatively managed stock/bond mutual funds, like the Vanguard Wellesley Income Fund (VWINX, at Line 28 in the Table), often substitute short-term bets on corporate bonds for longer term bets on US Treasuries. This has helped to maintain remarkably stable and strong returns for that asset class. VWINX has grown ~7.5% over the past 14 yrs and ~10%/yr over the past 5 yrs. You can separately invest in a corporate bond mutual fund at low cost. We like the Vanguard Intermediate-Term Investment-Grade Bond Fund (VFICX at Line 7 in the Table), which is itself hedged with US Treasuries as needed. See the Morningstar report for more information. VFICX has returned over 6%/yr long-term (e.g. since the S&P 500 Index peaked on 9/2000) as well as over the past 5 yrs. Note that the lowest cost S&P 500 Index fund (VFINX at Line 32 in the Table) has returned only ~4%/yr since 9/2000 with dividends reinvested. Without those gains from dividend reinvestment, it hasn’t even kept up with inflation! You get the point: A low-cost, investment-grade, intermediate-term, managed corporate bond fund is the Gold Standard hedge against stock market crashes.

Now let’s look at other options, like gold (see Week 175) and hedge stocks (see Week 150). Gold did well in the Lehman Panic but has terrible volatility (see Line 20 in the Table), and is still looking for the bottom in its current bear market. (Gold bullion has been falling in price at a rate of ~1.4%/mo for more than 3 yrs now.) An easier option is to pick stocks that hedge-fund managers are unlikely to sell short (see Week 150). The 17 stocks we’ve listed in that blog don’t need to be backed with bonds, since they’re unlikely to lose much money in a stock market crash. 

This week, we’ll look at a variation on that theme and screen the 20 stocks we’re aware of that lost less during the Lehman Panic than their long-term rate of return. In other words, they carry a positive number for Finance Value (see Column E in any of our tables). Five of those 20 companies appear on our list of Hedge Stocks (see Week 150): Wal-Mart Stores (WMT), McDonald’s (MCD), and 3 utilities:  Wisconsin Energy (WEC), Consolidated Edison (ED), and Southern (SO). We’ll call those Bond Substitutes. In the Table, we group those with corporate and international bond funds in a category called TREASURY BOND SUBSTITUTES.

Ten of the 20 stocks didn’t meet our criteria for stability, one requirement of which is to have a current price that is less than 10 times Tangible Book Value (TBV - see Column R in the Table). Another is to have an Enterprise Value (EV) that is less than 15 times Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). EV/EBITDA represents operating earnings relative to the market value of the stocks and bonds that capitalize a company (see column K in the Table). Now we have 5 companies that are hedge stocks (WMT, MCD, WEC, ED, SO) plus an additional 5 that are stable growers but have metrics that could make them attractive for hedge fund traders to “short.” Those 5 are Ross Stores (ROST), JB Hunt Transportation (JBHT), Hormel Foods (HRL), Occidental Petroleum (OXY), and QUALCOMM (QCOM). In the Table, they’re grouped with gold as LESS ATTRACTIVE T-BOND SUBSTITUTES. 

Upon applying the Buffett Buy Analysis (BBA in Column T; see Week 30), only WEC, ROST, QCOM look worthwhile for investment in this overheated market. Caveat Emptor: If you like these stocks, you’ll first need to assess the “story” that supports each company’s prospects for the future. Why? To determine if you want to buy into that story. You might decide the story is “broken” (or about to be), in which case you’ll look for something better to purchase with your retirement funds.

Bottom Line: We’ve introduced the thorny topic of “bond substitutes.” Gold is one such substitute. Stocks with a history of price stability in hard times are another (if they pay a dividend that persistently outgrows inflation). 

Risk Rating: 4

Full Disclosure: I own some Treasury Notes as well as shares of RPIBX, HRL, and MCD. I also dollar-average into WMT each month.

NOTE: Metrics in the Table are current as of the Sunday of publication.

Please leave comments below, or email to: irv.mcquarrie@InvestTuneRetire.com