Next Bubble: Corporate Bonds?

High-quality corporates looking frothy.

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story_images_bubbles(Reuters) – Tulip bulbs. Florida real estate. The Nifty Fifty. Gold. Japanese real estate. The Internet. Housing. History is littered with asset bubbles where investors piled into the next hot thing, only to lose much or all of their investments once the bubble bursts.

One leading strategist said the next bubble could be in something more mundane — high-quality corporate bonds — as investors burned after U.S. stocks fell by half from late 2007 to early 2009 flock to perceived safety.

And then, perhaps down the road, it could be the turn of some equities to become overheated again.

“Retail investors buying bonds today, at a time when the supply of corporate bonds is shrinking … they’re chasing a bubble,” Tom Lee, chief U.S. equity strategist at JPMorgan Chase & Co (JPM.N), said Wednesday at the Reuters Investment Outlook summit in New York.

“We had a credit bubble, a mortgage and housing bubble, and that caused equities to collapse,” Lee said. “I wouldn’t rule out equities as the next area where bubbles could emerge, but I don’t think it’s going to start in 2010.”

Many speakers at the Reuters Investment Summit have said individual investors remain cautious on stocks, despite a 13-month run-up that ended in April, saying net U.S. domestic stock fund inflows have been roughly nil.

In contrast, bonds are attracting bushels of cash. The intermediate-term bond fund Pimco Total Return PTTRX.O, the world’s largest mutual fund, has some $227.9 billion of assets, according to Morningstar Inc. And the average high-quality corporate bond yields 4.5 percent, a level last seen in 2004.

The love for bonds might not last, Lee said.

“Have Americans ever been satisfied with earning a steady rate of return?” he said. “What we have in American history, I think in capitalism, is rolling bubbles, whether it’s real estate, commodities, land speculation, emerging markets, time shares…. Basically, savers chase the next bubble, and then when that bubble shifts, they will move to the next one.”


Lee said prices on 10-year Treasuries and high-grade corporate bonds appear rich relative to the price-earnings ratio of companies in the Standard & Poor’s 500 .SPX.

Treasuries trade at about a 33 multiple, or the number of years it takes to earn $1 from $1 of principal, while corporate bonds trade around a 20 multiple, he said. But more than half the S&P 500 stocks trade below a 10 multiple, he said.

“Corporate balance sheets are pristine today, so the bond multiples are justified,” he said. “But the equity multiples are ridiculously low.”

Lee said the average yield on corporate bonds is just 2 percentage points higher than the S&P 500 dividend yield, the smallest differential since 1967.

“Corporate bonds are already (trading) at 108” cents on the dollar, he said. “If they were at 130, what would you do if you were General Mills (Inc) (GIS.N)? Buy back all your bonds, and issue new bonds at 3 percent. And then what does it mean for your stock? All of a sudden, maybe you de-equitize by 30 percent, because your cost of capital can justify it.”

General Mills bonds have risen in price. Its 5.65 percent notes maturing in 2019, sold in January 2009 at 99.91 cents on the dollar, traded Wednesday at 111.76 cents, yielding 4.03 percent, according to the bond pricing service Trace.

Kirstie Foster, a spokeswoman for the cereal maker, declined to comment, citing a “quiet period” before General Mills reports quarterly results.

Lee said improved corporate credit quality historically heralds increasing stock prices and could do so again.

He expects the S&P 500 index to rise roughly 20 percent by year end to about 1,300, saying it could easily support a price-earnings multiple above 14, compared with about 12 now.

“I think you get the no-brainer to buy stocks for the next decade, unless you just thought we were going to have the world economy shrink,” he said, “or if we’re Japan.”

© Thomson Reuters 2010.

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