The Magnificent Seven, But Not As You Know Them

Recession worries and bond yields are both higher than they’ve been in a while, and that bleak combo makes the prospect of portfolio diversification all the more important right now. Of course, that doesn’t mean you have to carve out a swath of your stock portfolio and give it over to the same dull bonds that everyone else is reaching for. What I’m saying is: instead of jumping at the usual US Treasurys, you could expand your horizon and consider corporate bonds, grabbing hold of the debt issued by some of the world’s best companies. You might be better off for it.

Why bother with corporate bonds?

Well, for starters, they’ve got fairly nice yields. Just have a look at an index of investment grade, A-rated corporate bonds. It’s at 6% now – its highest in a long time.

ICE BoA Single A-rated bond yields. Source: Federal Reserve Bank of St. Louis.

And then there’s the whole safety thing. Bonds are good portfolio diversifiers because they’re less risky than stocks. So when risk-lowering’s the aim, government bonds tend to be the game. But hold on a sec. Consider the following two companies…

Company A already has a debt pile of around five times the yearly income it pulls in. It also has costs – or spending – that are actually bigger than the income it generates, and it plugs that cash hole with even more borrowing every year, so its debt pile is constantly increasing.

Company B has debt that’s about half its yearly income, which is growing every year. So it actually has the capacity to clear all its current debt obligations with just a year’s worth of profit.

Now, let’s assume both entities want to borrow (i.e. issue bonds) with a ten-year repayment date. Which would you be more inclined to lend to? Company B, right?

Well, I’ve been a bit sneaky here, because company A’s profile matches that of the US government. Its outstanding debt – a ridiculous $33 trillion – is 5x the tax income receipts it pulls in every year. The government’s also spending more than it’s bringing in annually so that debt mountain is still growing (and it’s issuing bonds to fill the hole). Company B’s profile, meanwhile, looks suspiciously similar to Apple’s. Its balance sheet shows net debt (that’s debt minus any cash) of around $50 billion, and last year Apple raked in $100 billion in profit. So ask yourself again, which is the safest loan to make? (And: kudos to anyone who spotted the comparisons.)

I’m being a bit facetious of course. The US government’s income is spread across some 260 million taxpayers, all with different incomes and circumstances. Apple, meanwhile, is reliant on selling people iPhones (and other stuff). And while no one would expect Apple to run into any sort of financial trouble over the next ten years – certainly not enough to put its debt repayments at risk, given its healthy balance sheet – you just never know. People said the same about Nokia in 1999. But, on paper at least, you could say Apple is a better debtor than the government. Apple could – in theory – repay all its debt over the next few years. That’s something the US Treasury would give its right arm for.

So what’s the opportunity here?

If you think Apple is a pretty safe bet (and it probably is), then it’s worth noting that its bonds offer a better return than the US government’s. And, actually, Apple’s not the only one. This table shows the yields on the stock-market-leading “magnificent seven” firms (well, six, because Tesla only has one bond, and it’s a convertible one, so it doesn’t fit my argument and I’m leaving it out. I’m calling “poetic license”). The futures of these are extremely exciting – hence their stock price moves – so very few would question their long-term financial health.

Select magnificent seven bond yields, all around 10-year maturities. Source: Bloomberg.

I should point out that a yield pickup (a finance term for “improving your return a bit”) of 0.5% to 0.75% over the 10-year government bond (which currently offers 5%), isn’t jump-up-and-down exciting for most. But in the bond world, this counts as thrilling. Think of it this way: I can lend to two people, both of whom are almost certain to repay me, but I can get a 10% better repayment (0.5% is 10% of 5%) from one versus the other. It’s a bit like free money: you wouldn’t not take it.

So if you’re considering adding bonds to your portfolio, corporate bonds just might be the best way to go. If you ask me, at these yields, the magnificent six are pretty good picks.