I am not making recommendations to buy any stocks.
I am highlighting a group of stocks that meets a certain criteria in order to highlight an anomaly in the market.
I have no idea how long the anomaly will last.
I may own some of these stocks and may decide to buy more.
OK, with that out of the way, diligent readers may recall last year when I highlighted an incomprehensible disconnect in asset prices. Namely, there are a number of stocks which have dividend yields above the market yield on their 30 year debt.
Mathematically, this only makes sense if one believes either a) the stock will decline over the long term or b) the dividend will be cut but not in such a way that the ability to service the debt is threatened.
If you don’t believe either of those will happen, you can short the debt to buy the stock and be paid an annual premium to hold a 30 year call option on the stock. The only risk is near term market volatility.
To that point, the stock I highlighted last year, Exxon, is down 25% since I called it the Safest Trade in America. And I still would call it the Safest Trade in America given the long term arbitrage conditions still hold.
I’ve put together a list of 19 other highly rated companies that meet the same criteria. But before we get to that, let’s do a brief recap of what happened last week and what it means.
Putting Last Week In Perspective
You may have heard last week’s 13% sell-off described as the worst week for the market since 2008. This is true. Yet, it understates the gravity of what happened.
What if I told you instead it was the fifth worst week in the history of the S&P. And the second worst since 1933. That’s right it was worse than the week of Black Monday in 87. It was worse than the first week of trading after 9/11. It was worse than any week of a war or oil shock or other crisis.
On the other hand, the market was at this level less than six months ago. This isn’t March of 09 where we had given back ten years worth of gains.
We have also reached an interesting technical level. The 2018 sell-off started from a high of about 2900 on the S&P. It bottomed at ~2350. That 2900 is about where the current sell-off stopped indicating it is an important support.
Additionally, the market high was ~3400. Sell-offs often retreat about 50%. Halfway between 2350 and 3400 is 2875 which is right where the intraday low came in. So we ended the week at a very important level. That doesn’t guarantee it will hold, but given the sharpness of the selloff, there are reasons to think the 2900ish level is a strong firewall.
The 9/11 Comparison
Last week, I mentioned how corona is more like a hurricane than a recession, meaning it is a one time event that won’t persist. On reflection, an even better comparison is probably 9/11. That was also a one time event but it created fear it could be something far more ongoing.
Maybe people’s memories have faded now, but at the time there was a lot of concern that our way of life would permanently change due to recurring terrorist attacks. It wasn’t going to go away with a vaccine or better weather.
I can’t even tell you the panic at work the first time a fire alarm went off in the building post 9/11 (someone on a lower floor left something in the microwave too long I think). You’d never seen people run down 30 floors so fast in their life! Many of you probably saw similar reactions.
You can, in theory, protect yourself from the flu on a plane by not touching anything and wearing a mask. There was no way to protect yourself if you had the bad luck to get on a plane with a terrorist. People did not want to fly, period. Similarly, in public places, the flu doesn’t target you any more at the Super Bowl than at work or a restaurant, but the bad guys certainly targeted high profile events and people kept away.
The point being there was a lot more reason to cocoon after 9/11 than there is today. First, we don’t even have a breakout yet. Second, if we do get one, most people who get it will experience something analogous to the regular flu. Third, you can get medical treatment to reduce your risk of mortality if you get infected. If you happened to be walking through Times Square and a bomb went off, you obviously had no such recourse.
I don’t mean to make light of this, but the post 9/11 environment was far, far worse than this scare. Yet, two weeks after the 12% first week drop, the market had fully recovered.
For those wondering, but didn’t the economy tank? Eh, not really. The economy was already slowing. GDP was 2.3% in Q1, 1.1% in Q2, and 0.5% in Q3 (that had a small 9/11 effect at the end obviously). Q4 went to 0.1% but Q1 and Q2 of 2002 were both 1.3%.
So we basically had one bad quarter. Why would we expect this event to be worse? Remember, in an average flu season, more than 50,000 people die in the US. And yet, we all carry on with our lives most winters.
The idea that people will never go on a cruise again, get on a plane for spring break, go to a restaurant on Saturday night, or even go to the grocery store is refuted by the evidence from the 9/11 recovery.
The Safety Twenty
OK, back to the arbitrage story. While this disconnect between debt and equity markets has existed for some time now, the last week has amplified it.
I have identified twenty companies that meet the criteria:
1) Their dividend yield is > the market yield of their long term debt.
2) They have an S&P rating of A- or better.
In most cases, I have used recently issued 30 year debt. In one case, I could only go out 20 years. Then, there were some special circumstances where we can go as far as 76 years!
Before, I present the list, remember I am not saying to buy all 20 of these stocks. You have to do your own work on that. This is primarily a screen to identify high yielding stocks that are perceived as strong companies (as evidenced by an investment grade credit rating and their debt cost being so low).
I’m sure some of you will read the list and say XYZ doesn’t belong on it because of some problem with the company. I am not suggesting all these companies are clean. I am well aware that JNJ has significant liability risk – and yet it is a AAA and bond investors haven’t shown much concern.
One of the lessons of this exercise is typically the bond market shows fear before the equity market does. Yet, the anomaly in relative yields suggests either the bond market is complacent or equity investors are too anxious.
I’d also urge anyone that gets excited after reading this list to go back and read the original entry on this topic to make sure they understand the limitations (namely, it isn’t easy to short debt and I can’t predict when things converge).
Thus, without further ado, I present the Safety Twenty.
|Ticker||Div Yield||Debt Yield||Debt Issue||S&P|
|XOM||6.99||2.85||3.095 Aug 49||AA+|
|PRU||5.68||3.18||3.70 Mar 51||A|
|PM||5.63||3.23||4.25 Nov 44||A|
|ABBV||5.53||3.56||4.875 Nov 48||A-|
|IBM||4.87||2.95||4.25 May 49||A|
|PFG||4.79||3.09||4.30 Nov 46||A-|
|PFE||4.46||2.77||4.00 Mar 49||AA-|
|UPS||4.48||3.10||3.40 Sep 49||A|
|MET||4.01||2.89||4.60 May 46||A-|
|CSCO||3.60||2.59||5.50 Jan 40||AA-|
|MMM||3.92||2.92||3.25 Aug 49||A+|
|GILD||3.74||2.99||4.15 Mar 47||A|
|KMB||3.19||2.52||2.875 Feb 50||A|
|CAT||3.34||2.79||3.25 Sep 49||A|
|MRK||3.13||2.67||4.00 Mar 49||AA-|
|COP||3.56||3.18||5.95 Mar 46||A|
|PEP||2.80||2.54||2.875 Oct 49||A+|
|JNJ||2.73||2.51||3.50 Jan 48||AAA|
|CL||2.45||2.36||3.70 Aug 47||AA-|
|KO||2.99||3.65||7.375 Jul 93||A+|
The reason KO is negative is because it was a 100 year bond! It still has 73 years to go so I figured in that case a negative carry is acceptable (you could do an interest rate swap to get it to 30 years if you like and make the spread positive).
CSCO’s longest maturity is 20 years. You can add about 20bp to normalize it to a 30 yr maturity.
CAT also has a 50 year bond. It yields 3.15% and matures in May 2064.
IBM also has a 100 year bond. It yields 4.04% and matures in Dec 2096. Yes, you can paid to own a 76 year IBM call option!
While I won’t opine on the relative merit of owning any of these stocks unhedged, I think we can clearly say the disconnect between equity and debt markets violates the fundamentals of asset pricing.
While it may be difficult to practically short debt for 30 years, the cost of buying a call option in this manner is so massively cheap relative to a traditional call that someone should be working really hard to figure out the borrow side of the equation and create the arbitrage.
To put it in some perspective, a 2 year at the money call option costs about 10% of the price of the stock. I guess you could buy the 2 year call 15 times and pay 150% of the stock price…or you can get paid to own the call by shorting the debt.
The one group of people who can take advantage of this dynamic are corporate executives. By issuing debt on their company, they are essentially short it. They can invest personally in their stocks (or hold on to their stock awards) and collect a dividend above the debt yield. It isn’t quite a one for one match but it’s a reasonable proxy.
To wrap, good luck investing. Wash your hands. Remember, this isn’t as bad as 9/11. Markets tend to rebound faster than you think.
If I had to guess, I’d say the bottom will probably be a day or two after a pandemic is declared or some kind of other major headline (e.g. big spike in US cases) as at that point bearish sentiment will be exhausted.