In yesterday's column, I explained why government intervention is turning America's economy into a "vegetable economy."
The theory is, government bureaucrats are the worst allocators of capital in the world. Now that they control America's financial and real estate markets, the economy will stagnate. On the other hand, as long as the government continues shoveling out cash, there will be no more credit crunches, liquidity crises, or bank failures.
In today's essay, I'm going to show you why corporate bonds are the best investments you can own in this environment...
A bond is a loan. The borrower takes the money and promises to pay it back on a certain date and deliver a scheduled interest payment for the duration of the loan. This is the best outcome a bondholder can expect. In the worst outcome, the bondholder receives no interest and doesn't get the money back.
In other words, bondholders don't care about growth, profits, and business performance. Receiving interest payments and getting their money back is all that matters to bondholders.
This is why the vegetable economy will treat bondholders so well. In the vegetable economy, government programs practically guarantee solvency and liquidity. There won't be growth... but that doesn't concern bondholders. As you'll see, it rewards them.
Let's start with liquidity. When liquidity is scarce, it means few people are willing to lend money. When there isn't much money available to borrow, borrowers must pay higher rates to attract it. Climbing rates are bad for bondholders.
Liquidity became scarce in the credit crunch. Bond yields flew through the ceiling. One year ago, investment-grade corporate bonds paid investors yields around 6.5%. Today, they offer average yields of 10%. Right now, hundreds of companies are willing to pay you 20% or more in annual interest rates to borrow your money.
In the new vegetable economy, there's plenty of liquidity. It's coming from the government and Federal Reserve. They've already bought billions of mortgage bonds and agency bonds (by "agency," I mean Fannie Mae, Freddie Mac, and similar institutions). They've guaranteed money-market funds and state investment pools. Now they're aiming their fire hose at the municipal-bond market.
With the Fed and Treasury trying to artificially lower rates on agency, mortgage, municipal, and Treasury bonds, they're making corporate bonds look especially attractive. Liquidity will flow to corporate bonds, pushing up prices, depressing yields, and rewarding everyone who owns them.
Liquidity is also coming from other markets. In the vegetable economy, growth-sensitive investments like stocks, commodities, and real estate are dogs. When growth investments lose their appeal, liquidity increases in the bond market.
The government is ensuring liquidity and passing the rewards to bondholders. But what about solvency?
Credit risk is a measure of a company's creditworthiness. A company that struggles to pay its bills will have to offer much higher rates than a company with cash in the bank and rising profits.
When the Fed let Lehman Brothers fail, and it looked like it wouldn't step in to save anyone else, credit risk leapt through the roof. No company was immune from lenders' suspicion, even Berkshire Hathaway.
But now, the government has said it won't let any other companies fail. The Federal Reserve said it will do whatever it takes to maintain stability. In the vegetable economy, solvency is all but guaranteed. If companies are solvent, they pay their bondholders.
Corporate executives are also focused on solvency. Last year, CEOs talked about growth plans, access to debt, and earnings increases. On conference calls these days, you hear CEOs focusing on their cash balances, debt obligations, and interest-coverage ratios.
In recessions, it is more important to prove to investors you're solvent than it is to show them you can grow earnings. In other words, safety trumps growth. Corporate managers will shore up their balance sheets at the expense of future profit potential. They'll cut dividends, fire employees, cut expansion plans, and take steps to improve their balance sheets. Bondholders win at the expense of stock holders.
In sum, today is the Golden Age of Bond Investing. The two most important issues for corporate bondholders are solvency and liquidity. Thanks to the government's intervention, we have both right now.
Good investing,
Tom
P.S. When the fear of inflation returns to the market, you'll want to sell your corporate bond investments. Next week, I'll tell you the best inflation indicators to monitor...
Editor's note: Tom Dyson is a regular contributor to DailyWealth, a free investment newsletter focused on the world's best contrarian opportunities. We write with a simple belief in mind: You don't have to take big risks to make big money with your investments.
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