"Right now, bonds should come with a warning label."
Legendary investor Warren Buffett gave Fortune magazine that quote in February... during what should be remembered one day as the "Great 21st Century Bond Bubble."
And Buffett (as he often does) makes a good point... For example, who would lend money for three years and accept 0.75% per year in interest?
Nobody, you say? In fact, on March 14, a lot of people lent Coca-Cola $750 million until 2015 at 0.75% per year. That same day, Coca-Cola also issued $1 billion in bonds due 2018, paying just 1.65%.
This is great for Coca-Cola... It can borrow money for nearly nothing and buy back its stock (which pays a 2.9% dividend yield) all day long.
Coca-Cola has super-safe credit. If anyone deserves to borrow at 0.75% for three years, it's Coke. But credit risk is not the issue... inflation is. The new bondholders are virtually guaranteed to see the value of their investments dwindle in inflation-adjusted terms.
Pick your inflation gauge... The Consumer Price Index (CPI) – which ostensibly measures the prices individuals pay for everyday goods – says inflation is 2.9%. The Producer Price Index (PPI), a measure of what businesses pay for the materials they need to make goods – says inflation is running at 3.3%. Let's split the difference and call it 3%...
It's like you invested $100 and, a year later, found out your $100 was worth $97... But hey, it's OK because you received $0.75 in interest payments. Can you imagine being perfectly happy with making $0.75 on every $100 you invested?
Even at 2% inflation (the Federal Reserve's recently announced target), these bond yields are still a lousy, losing deal for investors.
In the current issue of The 12% Letter, due out today, I offer the following as a reasonable definition of a financial bubble: In a true financial bubble, the price of the asset becomes totally unhinged from the reality of its underlying fundamentals.
When it's possible to borrow $750 million for three years at 0.75%, bond prices have become unhinged from the reality of the underlying fundamentals.
And you can find plenty worse examples of bubbly bond prices. A German cement company called Heidelberg Cement recently borrowed 300 million euros for four years at a rate of just 4%. Can you imagine lending a capital-intensive, cyclical business like cement production 300 million euros and charging just 4%? I just can't.
It all reminds me of how Nicholas Nassim Taleb – money-manager and author of the book The Black Swan: The Impact of the Highly Improbable – described the stock market. Market participants, he said, are calmly lined up to be slaughtered, while thinking they're waiting for a Broadway show.
According to data from research firm ICI... since June 2008, investors have made net withdrawals of $376.1 billion from equity mutual funds. During the same period, they've poured nearly twice that amount ($723.6 billion) into bond mutual funds. Despite the huge rally since 2009, they're still terrified of stocks and fleeing to the safety of bonds. Bonds have become a sort of "safe income" bubble as investors continue to fall out of love with stocks. (Yes, despite the rallies and the positive sentiment indicators.)
So the bond market is experiencing a bubble. Making money in bonds at these yields is unlikely after inflation gets done with you. Overall, their prices are unhinged from their fundamentals, and you're crazy to buy them.
But maybe there's another reason people are buying these bonds... a corollary to having the value of our money sucked out by the Fed's low interest rates and money printing...
A quick trip to bankrate.com – a website that allows you to compare rates on mortgages, CDs, credit cards, etc. – shows you can get a three-year CD that pays between 1.3% and 1.5% – roughly double the interest on a three-year Coca-Cola bond.
So... maybe the world thinks it's riskier to give your bank $100,000 for three years than it is lending your money to Coca-Cola. That's probably true.
As we noted in this week's Digests... co-editor Sean Goldsmith is in the Asian financial center Hong Kong, attending the Mines & Money conference. Sean reports the mining companies presenting at the conference are also taking advantage of record-low interest rates...
Donald Lindsay, CEO of Teck Resources, the $21 billion Canadian miner, couldn't stop smiling as he told the audience about his firm's bond sale last month... On February 16, Teck sold $500 million of notes due in 2019, paying 3% and $500 million of notes due in 2042, paying 5.2%. Lindsay did some quick math and said the real yield (after tax and inflation) on the 30-year debt is around 1%. Would you lend money to a business in one of the most cost-intensive, lowest-margin businesses in the world for a real yield of 1%?
Another presenter, Peter Kukielski, head of mining at ArcelorMittal, also spoke about his company's recent borrowing. ArcelorMittal is the world's largest steelmaker. Last month, the Indian company issued $3 billion of notes due in three, five, and 10 years. The $500 million of three-year notes yield 3.75%. (Remember, similar maturity U.S. Treasurys are yielding about 0.6%). The company also sold $1.4 billion of 4.5%, five-year notes. (Similar maturity Treasurys yield about 1.2%.) And it sold $1.1 billion of 6.25%, 10-year debt. (Similar Treasurys yield 2.3%.)
Lei Mu, executive director of China Development Bank International, must be a celebrity in China... Attendees at the Mines & Money conference were standing in the aisles, snapping photos of him as he spoke to the audience. He told the attendees his bank has around $1 trillion in assets. That's about half the size of Bank of America's $2.1 trillion in total assets... But according to many, CDBI is the world's largest bank, based on loans outstanding.
Most impressive, Lei Mu said his bank has a nonperforming loan (NPL) ratio of 0.45%... the lowest among all Chinese banks. (Bank of America has an NPL ratio of 3%.)
In China, commercial banks represent 70% of all financial activity. And CDBI is the only bank in China allowed to make private-equity investments. Last year, the bank completed 65 transactions worth 45 billion renminbi (China's currency). It's the second-largest shareholder in Chinalco, the state aluminum company. It's a major shareholder of Jinchuan, the largest nickel smelter in Asia, and CECIC, the largest environmental-protection firm, among many others.
And the bank is putting lots of capital to work outside the country. It currently has $250 billion of loans outside China. And since 2003, the compound annual growth rate for loans outside the country is 49%.
When asked in which countries and sectors his bank will invest during 2012... Lei Mu's answer was general... Eastern Europe, Latin America, and Africa are his favorite areas for investment. And he said he focuses on products China needs – precious metals, iron ore, coal, copper, and nickel.
Note the first item on the list of assets... precious metals. That should come as no surprise to Digest readers. Here at Stansberry & Associates, we've been covering what we believe is China's secret plan to corner the world's gold markets. The plan goes beyond simply buying bullion off the world's markets. And if successful, this secret plan could have a dramatic effect on the standard of living for millions of Americans. We've produced a video describing what we've discovered. To watch the video (and learn how to access the accompanying report), click here.
New 52-week highs (as of 3/21/12): V.F. Corp (VFC), Anheuser-Busch InBev (BUD), Clean Energy Fuels (CLNE), and Intel (INTC).
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Hong Kong and Medford, Oregon
March 22, 2012
Warning: 0.75% yields!... The bond bubble... "Lined up for slaughter"... Sean from Hong Kong... Miners borrowing at 1% interest... Where China is investing...