Tad,

Thanks for the detailed response. This is basically what I thought, but
you put a lot more meat around the issue.

-Will

Will Trice wrote:
- quote -

Will-
I saw that article and it had me scratching my head. I think the whole
inflation issue is kind of a red herring because there are some more
fundamental problems. It seems like a strategy right out of academia -
that observes "stocks are riskier than bonds" and builds from there
without looking at some of the details of the transaction. There's risk
in there and it's not the kind of arbitrage where profit is guaranteed.

They're not looking at preferred stock or convertible bonds, special
cases where I can think of true arbitrage trades.

A basic issue is that a common stock's dividend can be cut, whereas bond
interest and time of repayment is essentially set in stone. So you might
turn up some companies that are about to cut their dividends (or that
the market thinks...). That's a problem because the trade works only
when you collect enough dividend to pay the interest to the owner of the
bond that you borrowed and sold.

Also tax treatment is different for these two securities and they should
talk in terms of after-tax yields. I guess that would favor the stock in
most cases, but they mentioned EOP which had return-of-capital as part
of its dividend - that's not a true dividend IMO.

Also it seems odd they don't talk about protecting against a drop in
stock price using a put option, which again would make it more of an
arbitrage trade. What if the stock price dips between now and the
maturity date of the bond - how would you repay the bond? I don't think
this is so out-there as a risk. Remember when Citi had all those Latin
American loans? Isn't there a fear that WaMu has profits too tied to
refinancings?

Plus it doesn't consider some of the limitations investors have when
shorting securities. I'll give the benefit of the doubt and say the
article was directed at institutional investors.

Last, the inflation subtraction...again, straight out of academia.
Starting with: is CPI at all relevant to this specific company's
business? Aren't they implicitly trying to predict inflation in
describing the trade?

I do think high dividend yields vs. bond yields are worth a look at the
"story", to assess the stock as a long-term investment. But not as a
true arbitrage trade. To me this is one of the weaker "strategy"
articles I can recall in the WSJ, it has a lot of "yeah, but..." caveats.

-Tad

Will Trice wrote:

- quote -

Sorry, this should have been:

bond yield - inflation > = dividend yield

-Will

So now I understand Beliavsky's post as well. Is it common to consider
the stock such a good buy (and the bond such a good short) that this
would be an arbitrage situation?

Thanks!
-Will

beliavsky[at]aol.com wrote:

- quote -

Sorry, I'm still confused. How does your statement above translate into
the following hypothesis:

bond yield + inflation > = dividend yield

And that when actual data violates this hypothesis an arbitrage
opportunity is available?

Thanks!
-Will

The stocks are believed to be a good bet against inflation. What is
inflation? Take a moment to think about it. Let's assume all american
companies collectively earn $100 this year. Also picture the inflation
at 3%. That means that the prices rise 3% in one year. Where does all
this price increases go? They show up on the balance sheet of the
corporations as nominal profit growth. This 3% inflation rate will
cause the total profit for the american companies to rise to $103 next
year. If P/E stays constant, then stock prices will rise by 3% also.
The dividends will rise by 3%. Your nominal pay will increase by 3%.
The house prices will go up by 3%......... In an ideal world, of
course!!! You get the point. That's why if the stock pays higher
dividend then bond minus inflation, then it should be a good buy,
assuming if the stock price does not fall.

http://therealreturns.blogspot.com

Will Trice wrote:
- quote -

The underlying assumption is that in the future the company's revenues,
profits, dividends, and therefore stock price will grow as fast as
inflation. If the stock price rises at rate i and the the dividend
yield stays constant at d, the total return will be (i+d).

There is no guarantee that a company can increase its dividends at the
rate of inflation.

On page C3 of the Wall Street Journal on 1/25/05 was an article
entitled, "Market Anomaly May Lead to Profit." This article mentions
several companies whose bonds *less inflation* pay less in interest than
the dividend yield on the common stock. The author (Karen Richardson)
considers this an arbitrage opportunity and suggests that investors may
want to buy shares of the stock and short the bonds. One of the
companies mentioned was Citigroup, whose common shares I already own, so
I checked on the details. The bond yields are actually greater than the
dividend yield of the common stock, but if you subtract out a nominal
figure for inflation from the bond yield, then the dividend yield is
indeed higher.

So what? I'm clearly missing something. I understand that if the
common stock and the bonds behave normally then the bonds can be
expected to have a higher yield than the common stock (which they do).
But why should this still be true after I subtract the inflation rate
from the bond yield (i.e. the bond yield should be greater than the
dividend yield by at least the rate of inflation)?

Any thoughts y'all might have would be appreciated,
-Will