Bond Bubble Brewing

McDonald's (NYSE: MCD  ) definitely didn't price last week's bond issue off the Dollar Menu. The company issued new 10-year bonds with only a 3.5% coupon, and The Wall Street Journal reported the issue had the lowest interest rate for a 10-year U.S. corporate issue in at least 15 years.

The bond pricing is interesting since McDonald's stock yields more than 3%, and if it continues its trend of annual increases, the payout will be super-sized again this fall. Odds of those bonds having a yield premium over the stock at today's price by the end of 2011 are about the same as taking a long road trip and not seeing a Golden Arches somewhere near a highway exit. In short, the bonds look expensive, at least relative to the stock.

Since single data points don't tell a full story, I looked for other high-quality dividend growers with bonds that appear overvalued relative to the stock. The table below shows examples with each stock's dividend yield, an assumed dividend growth rate, bond maturity date and yield, and how many annual dividend hikes before the stock yield passes the bond yield. To be conservative, the assumed dividend growth rate is the smaller of the three-year dividend growth rate, the five-year dividend growth rate, or 10%.

Company

Dividend Yield

Assumed dividend growth rate

Bond Maturity

Bond Yield

Hikes Needed to Top Bond Yield

McDonald's

3.13%

10%

07/15/20

3.55%

2

Procter & Gamble (NYSE: PG  )

3.11%

10%

09/01/24

4.49%

4

IBM (NYSE: IBM  )

1.99%

10%

11/01/19

3.74%

7

Kraft (NYSE: KFT  )

3.93%

5.94%

02/10/20

4.15%

1

Heinz (NYSE: HNZ  )

4%

6.56%

07/15/28

5.68%

6

Chevron (NYSE: CVX  )

3.70%

7.93%

03/15/20

4.55%

3

ExxonMobil (NYSE: XOM  )

2.84%

8.61%

08/15/21

4.15%

5

Sources: The Motley Fool, FINRA.org, and author's calculations.

In all these cases, the bonds don't offer much income advantage over the stock, the spread evaporates pretty quickly, and with record low yields, the bondholders aren't getting much protection against inflation risk.

For companies with debt coming due and good credit ratings, these rates are a gift. Rolling debt over at today's rates lowers interest expense -- freeing up cash flow for capital expenditures, acquisitions, or returning cash to shareholders.

Evidence of a bond bubble? Maybe, maybe not. Even if bonds are bubbling, that bubble may keep inflating for quite some time. Are bonds expensive? I think so. Bubble in with a comment to share your opinion.

Related Foolishness:

Fool contributor Russ Krull owns shares of McDonald's and Chevron, but no other companies mentioned. The Fool has a disclosure policy that has never been in a bubble.


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  • Report this Comment On August 03, 2010, at 8:43 PM, dth20k wrote:

    Stocks offered a higher yield than bonds from the Great Depression through about 1958. This was considered normal, given the extra volatility associated with equities, the ease with which dividends on common stock could be cut, and common stocks low position in the capital structure in case of liquidation. I agree that bonds seem pricey now, but then again, the most hawkish members of the Fed are now raising the specter of QE2 (quantitative easing, part two). If the Feds buy trillions in long term treasuries, lowering the yield below 2%, well....

  • Report this Comment On August 03, 2010, at 11:41 PM, rd80 wrote:

    @dth20k - Thanks for the comment and additional points. One of the characteristics I looked for was stocks with little credit risk and long-run, stable businesses to take as much default or dividend cut risk off the table as possible.

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