Bond Bubble Sample And ALLY

Many investors, especially retirees, understandably are focused on generating income from their investments.  Historically, bonds have been one of the best ways to achieve that, with less volatility than equities.  While history can be a fantastic guide to what can potentially happen in the future, looking at recent data on fixed income returns could not be more misleading.  Record-low interest rates and global quantitative easing have driven bond yields to historic lows.  The upside is paltry, and the downside is massive for future bond returns.

To put numbers to that, the BAML U.S. High Yield Index, has an effective yield of 5%.  The BAML U.S. Investment Grade Bond Index, has an effective yield of 2.61%.  These numbers are simply staggering as those yields are before the very real costs of inflation and defaults.  Remember that unlike stocks, bonds do not grow in value, like a business’s earnings stream might.  The risks are completely asymmetrical, as any increase in rates, inflation, or spread to Treasuries, would lead to substantial losses.  These losses could easily wipe out years of income from these paltry rates.

The reality is that if you are invested in bond mutual funds and/or bond ETFs, you are not only invested in these types of bonds, you also likely own government bonds at negative interest rates.  That is the danger to funds in that you usually don’t know what you own specifically.  Most people wouldn’t buy these bonds when looking at the individual characteristics, but in a fund one just piles into the abyss.  When interest rates go lower, these investors are bailed out, as that helps the bonds gain in value.  At some point…..rates must go up, and if there is a whiff of inflation, it could happen far sooner than most would believe.

One stock that we really like a lot, ALLY Financial (ALLY), dropped by about 11% after an acquisition of a credit card company spooked some market participants.  The stock is trading at around $28.33 per share, which is about 7 times earnings.  The dividend on the stock is now 2.36% and has been growing by 23.86% on average over the last 3-years.  In addition, the company is buying back stock representing about 10% of its market capitalization, at these discounted prices.  This is clearly more attractive than any of these bonds we can buy and the stock has upside to at least $40.

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