“Come With Me if You Want to Live”: Your Bridge From Bonds to Stocks (With a Nice Yield)

Bill Gross’ takedown of stocks has garnered plenty of pushback (GMO asset allocation chief Ben Inker’s patient demolition of the “death of the cult of equities” is a must-read.) But what seems to be getting lost in some of the squabbling is that Gross wasn’t exactly making a case for bonds either. The head of the world’s largest bond management company had this to say about his wheelhouse:

“Capital gains legitimately emanate from singular starting points of 14½%, as in 1981, not the current level in 2012. What you see is what you get more often than not in the bond market, so momentum-following investors are bound to be disappointed if they look to the bond market’s past 30-year history for future salvation, instead of mere survival at the current level of interest rates.”

10 Year Treasury Rate Chart

10 Year Treasury Rate data by YCharts

The chief economist for Vanguard concurs. In a blog post this week, Joe Davis, who is also head of the firm’s Investment Strategy Group had this warning:

“We as investors first need to recalibrate our expectations for future bond returns. Unfortunately, the most direct implication of this low-rate environment is that bond portfolio returns are likely to be fairly puny going forward.”

Davis also mentioned the V-word. “With current bond yields low, interest rates lower, and the economic outlook cloudy at best, Vanguard doesn’t think future bond returns will be nearly as robust as they’ve been. In fact, looking forward, we’re inclined to expect significantly elevated levels of volatility in the bond market.”

None of that should be misconstrued as a reason to bail on bonds. A well-diversified core bond portfolio is the much needed ballast for a long-term investment strategy. (That is, unless you possess the nerve to fly through market freefalls without a safety net below.) Davis’ post is well worth a read for his thoughtful take on why the much anticipated rise in interest rates isn’t on some short-leash schedule. Just look how long Japan has been waiting.

But if your portfolio has taken on a serious list to the bond side the past few years (fund flow data suggests it has…in a big way) now seems like a good time to right your ship by rebalancing to add back more stocks.

The classic way to segue back into stocks is to head for the defensive sectors with the highest yields. Careful with that approach. Yes, the utility sector has yields that make bonds (and stocks) blush. The 3.8% yield for the Vanguard Utilities ETF (VPU) is almost double the payout for the Vanguard Total Stock Market (VTI). And that’s helped push its total return to outperform since the start of the second quarter, when the specter of slower economic growth took hold here and abroad.

VPU Total Return Price Chart

VPU Total Return Price data by YCharts

But yield hungry investors have bid up many utility stocks to near nose-bleed levels. You get yield, but also the prospect of some nasty volatility when the economy moves forward and defensive stocks-especially pricey ones-lose their allure.

A better place to shop for some yield and better value is in mega-cap stocks, which in general are trading at below-market valuations.

Some leads? Okay. How about that in its just released second quarter portfolio report, Berkshire Hathaway (BRK.B) reported its still buying more shares of Wells Fargo (WFC) and IBM (IBM).

Wells Fargo hasn’t seen its price/earnings ratio follow its price up, and the current dividend yield is 2.6%.

WFC PE Ratio Chart

WFC PE Ratio data by YCharts

IBM’s PE ratio has moved along with the strong price performance, but it’s not exactly expensive.

IBM Chart

IBM data by YCharts

IBM is clearly delivering on some key metrics, while also paying a 1.7% dividend yield at today’s $198 share price.

IBM Free Cash Flow TTM Chart

IBM Free Cash Flow TTM data by YCharts

There’s also the mega-iest of the mega caps, Apple (AAPL) which still sells at a pretty sweet valuation.

AAPL Chart

AAPL data by YCharts

Apple just started doling out a dividend; on an annualized basis it works out to a dividend yield of 1.7%. Not exactly the 4% payout of a utility, but that 1.7% is more than the yield on a 10-year Treasury. And while there’s always volatility to be expected in any stock, there’s more potential upside in Apple over the long-term, than a pricey utility, or a bond paying 1.7%.

Carla Fried is an editor for the YCharts Pro Investor Service which includes professional stock charts, stock ratings and portfolio strategies.



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