By Tom Bradley

In the investment business, valuation comparisons are very important. How one security stacks up against another in terms of price to earnings ratio, cash flow multiple or yield is at the core of what we do. CP Rail is cheaper than CN because it has a lower price to earnings ratio. A BMO bond is attractive because its yield is higher than a similar RBC issue.

One of the most common points of comparison that we use is the yield on government bonds, which is often considered a proxy for the risk-free rate. In this space, it's been said often that corporate bonds are an attractive investment because their yields are 3-4% above Government of Canada bonds. In making the case that now is the time to start buying equities, we've pointed out that the stock market's dividend yield is running well above the yield on Canada bonds - the TSX Composite Index is yielding 3.8% and the international markets are even higher at 5.0% (the EAFE Index).

I'm not backing off from that stance, but do think we have to be careful when using the Government bond as a comparison. In any such assessment, we must evaluate both sides of the equation. In this case, we have to temper our view as to how cheap corporate credit and stocks are by the fact that Government bonds may be overvalued. Yields of 0.5% to 3.5% (depending on the term) look inadequate to compensate for the potential of rising inflation in the medium term. As noted in a recent posting, Warren Buffett goes so far as to say that U.S. Treasuries may be the next bubble.

Note: I'm not suggesting that investors won't get their money back when their Government bonds mature, but rather that with miniscule yields and the potential for higher inflation, holders may experience negative returns along the way. In other words, there is an opportunity cost to holding Canada's and Treasuries.

If we are right that safety is expensive and risk is cheap, then there are a number of ways this situation can work itself out. Changes can happen on both sides of the comparisons.

• Bond spreads will narrow by (1) corporate yields coming down (good) and/or (2) government bond yields going up (bad).
• The gap between dividend yields and bond yields will decrease when (1) stocks go up (Yahoo!), (2) bond yields rise (bad), and/or (3) dividends are cut (bad).
  It is quite likely that all of those things will happen to some degree.

As investors, we sometimes get sloppy in our analysis. We assume something is a given (government bond yields, China's growth, oil shortages) and work from there. In reality, the given is every bit as variable as the thing we're comparing it to.