The Economy by Peter R. Crabb: Low interest rates drive bond investors toward stocks

PETER R. CRABB, professor of finance and economics at Northwest Nazarene University in NampaMay 21, 2013 

Peter Crabb

We're back in business. After years of avoiding stocks, investors are once again seeking the better returns of the equity markets.

The Dow Jones Industrial Average passed its historical high from just before the financial crisis and is now up more than 12 percent on the year. Meanwhile, the bonds that investors favored through the crisis and beyond are yielding only 2 percent. After adjusting for inflation, that is basically nothing.

With the stock market moving to new highs, more companies are raising equity capital rather than borrowing more. The Wall Street Journal reported that U.S. companies are on track to raise more money this year through initial public offerings (IPOs). A local example is Boise Cascade Co., which brought in $248 million when it returned as a public company in February.

But with the economy growing well below average and unemployment still well above what is considered normal, what is driving investors out of bonds and into stocks?

Some analysts have pointed out that since the U.S. Federal Reserve is artificially suppressing interest rates, investors have no choice but to move their money out of bonds and into risk investments like stocks. Such support for the stock market is likely to evaporate quickly as soon as the Fed switches gears and starts raising the interest rates it charges banks.

While this creates a large risk for investors, another risk factor in stocks is on the decline. Managers at public corporations are doing a better job keeping the interests of shareholders first and foremost.

Financial markets have long been troubled by conflicts of interest. The love of money, which flows generously through large public corporations and the financial markets, too often leads generally good people down the wrong path.

Economists define this issue as a principal-agent problem, or simply an agency problem. Problems arise in any market whenever one person (the agent) contracted to act on the behalf of another (the principal) has a conflict of interest. That is, the interests of each are not well aligned.

At large corporations, the principals (i.e., stockholders) hire the agents (i.e., managers) to act on their behalf. Given our human nature, it is unrealistic to believe that these agents will always put the interests of stockholders ahead of their own. Managers sometimes choose not to work hard enough, grant themselves excessive compensation, or simply try to build their own empire by growing the company too fast.

Corporations use numerous arrangements in an attempt to ensure that managers' actions are consistent with stockholders' objectives, and they have put in more controls since the 2007-2009 financial crisis. Such changes include "carrots," which link the manager's compensation to the success of the firm, or "sticks" that create an environment where poorly performing managers are quickly removed.

More corporate executives today are receiving their pay in the form of restricted stock. Under these programs the executive only gains if the stock price rises in value over many years, not just a few months as is the incentive underlying executive stock options. The newly public Boise Cascade Co. is using restricted stock compensation for some of its managers.

Restricted stock is a good carrot. The best stick is a competitive market.

Earlier this month, shareholders in Occidental Petroleum cast their shares against Ray Irani, chief executive officer since 1990, by more than a 3-to-1 margin. Irani was perhaps the most entrenched executive of the past two decades and his ouster is a sign of more to come. The increasingly competitive global market for both capital and executive talent is holding executives more accountable.

Yes, interest rates may be artificially low and investors must look to stocks in order to stay ahead of inflation, but today's competitive markets provide more assurance that investors' interests are protected.

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prcrabb@nnu.edu

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