Don't Invest With the Rearview Mirror

Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser. I'm here today with Morningstar DividendInvestor Editor, Josh Peters, who recently saw an interesting bond issue from Johnson & Johnson.

Josh, thanks for joining me today.

Josh Peters: Happy to be here. Not often that I come on and talk about bonds, but this is a little different bond.

Glaser: No. I think, this might be a first for Dividend Investing. What did you find so interesting about this particular J&J issuance?

Peters: Well, one is the interest rate, just 2.95%, and this is a 10-year bond. This is a 10-year relationship with this company, where you're guaranteed that you will not earn more than 2.95% a year if you hold this bond to maturity. That's a little bit of a premium to where a 10-year treasury bond is – I mean, Johnson & Johnson is not quite the U.S. government, but still a pretty narrow spread and a very low nominal interest rate.

What makes it even more interesting is to compare it to Johnson & Johnson's common stock. On the day that this bond was priced, the common stock closed with a yield of 3.69%. So there just by moving from this bond to the stock you pick up yield that is a very rare type of relationship, and these kind of situations are only now really starting to crop out with interest rates so low.

Glaser: Why do you think that's happening then?

Peters: I think it's really coming down to people just becoming determined to own bonds for the sake that they're bonds. And I can understand and I'm certainly sympathetic with the fact that stocks have performed very poorly in the aggregate at the market as a whole over the last decade. They haven't provided the kind of returns that people have been expecting as they try to save for retirement. They've been volatile. A lot of stocks have lost value over the last 10 years.

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There's been a lot to make somebody cautious. And in fact I think that this is a trend that's going to continue. More people are going to think I just don't need this headache any more of trying to own stocks, trying to get some kind of a decent return out of common stocks. But when you flip it around and you say that these bondholders and these stockholders are both essentially expressing a favorable opinion of the same company and you are actually thinking in terms of, I would rather own that bond even though it yields less than the stock and I have no possibility of growth, I have no hedge against any kind of increase in inflation, in fact, Johnson & Johnson stock price could be lower 10 years from now than it is today and because the dividend yield is starting out bigger and because that dividend is almost certainly going to grow at a good rate over the next 10 years, I mean the kind of scenario where you actually come out ahead owning the bond is just very hard to imagine.

Glaser: So, certainly from a portfolio allocation perspective, obviously, you are going to have some of it allocated to bonds, but you think it could be a mistake to kind of grow that allocation maybe even beyond where it should be and kind of give up these opportunities in stocks like Johnson & Johnson?

Peters: Yeah, I mean you just – you never want to be investing with only the rearview mirror. That's probably going to steer you just into a ditch or into a light post, you know like you – what if you are trying to work a car. Past performance can provide valuable lessons as to what may work in years to come, but chances are, whatever has been the most popular investment for a long period of time is starting to get pricey, values are becoming inflated.

I think a lot of people say, well, if it's a bond, I can't lose. I might not make much, but I might – but I can't lose. Well, bonds' interest rates probably not going to go below 0%, but you can lose a lot of the purchasing power of that investment if inflation rises, just ask anybody who bought long term treasury bonds in the 1960s, they got clobbered.

So you have to start thinking about whether or not this relationship has started to get out of balance again. When the stock market finished up in 1990s it was at very high levels, treasury yields were actually pretty good, those – you can see where the ground had been set for stocks to do poorly and for bonds to do well.

Now, I think, you seek comparison like this. Johnson & Johnson 10-year bond issue that yields less than its own stock, I was maybe telling you that we are getting to a point where that relationship is going to start to flip flop. If anything, I am actually taking this as kind of a positive sign on the market that perhaps things have gotten so silly in the bond market that stocks are going to start to push back.

Glaser: Josh, thanks for talking with me today.

Peters: Happy to be here.

Glaser: For Morningstar.com, I am Jeremy Glaser.