Investing for Income
[NC] Peter Boockvar, CIO of Bleakley Advisory Group and editor of the excellent Boock Report, states that a Fed-driven credit cycle now supersedes the traditional business cycle. Since debt drives so much GDP growth, its cost (i.e. interest rates) is the main variable defining where we are in the cycle. The Fed controls that cost—or at least tries to—so we all obsess on Fed policy. And rightly so. . .
[NC] Among other effects, debt boosts asset prices. That’s why stocks and real estate have performed so well. But with rates now rising and the Fed unloading assets, those same prices are highly vulnerable. An asset’s value is what someone will pay for it. If financing costs rise and buyers lack cash, the asset price must fall. And fall it will. The consensus at my New York dinner was recession in the last half of 2019. Peter expects it sooner, in Q1 2019. (from John Malden's excellent free letter "Thoughts from the Fontline." Subscribe by clicking here.)
[NC] At its January 2019 monetary policy meeting, the Federal Reserve (Fed) kept its benchmark interest rate unchanged. The Federal Funds Rate is in a range of 2.25% to 2.50%. At that time, the Fed indicated that it could leave rates alone in coming months, given global economic pressures and mild inflation. It is prepared to slow the reduction of its bond holdings if needed to help the economy. The probability of a rate increase at the next Fed FOMC meeting can be found here. http://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html[NC] John Mauldin, on 12/29/18, stated "I find it just as plausible that the balance sheet reduction is as responsible for the market volatility as the increased rates. If QE made the markets go up, especially in concert with the ECB, the Bank of England, and the Bank of Japan, then it’s no surprise if ending it makes the markets fall."
[NC] The yield spread is shown below since 1996 where a negative spread indicates an inverted yield curve. The flattening yield curve is often a warning of a slowing economy and a potential stock market peak. An inverted yield curve generally forecasts a future recession. It has preceded all of the past seven recessions since 1970, typically by four or five quarters. Although the 5-year Treasury yield recently went below the 2 and 3-year Treasuries, this has not been a good indicator of a future recession.
[NC] A dynamic yield curve can be found at http://stockcharts.com/freecharts/yieldcurve.php.
[NC] The rates in Europe and Japan are negative for many bonds. Yields and history of global government bonds can be seen by clicking here.
[NC] Allocations for a portfolio can be divided into bonds (or other income funds), dividend-paying stocks and cash. Cash can be kept in a brokerage money market fund. An interest paying savings account is another approach and selections can be found here. The purchasing power of cash will deteriorate about 2% a year due to inflation. Short-term bond funds and bank-loan funds would be other lower-risk considerations. Ultra-safe 3-month Treasury bills are yielding over 2.4% (see above chart) and these could be rolled over every three months to get the next higher interest rate. The percent kept in each of these depends on your risk tolerance. Rebalancing to maintain your percentages can be done periodically. May and October are suggested as this would synchronize with the Power Zone.
[NC] Most equity index funds are capitalization weighted -- meaning the largest corporations get a greater percentage of the money invested in the fund. Bond index funds are different. They are structured according to the amount borrowed by the corporation. The largest borrowers get a higher percentage of the fund's invested money. The corporations' capacity to service their debt is not considered. Active bond managers aren't bound by the requirements of an index. Rob Arnott of Research Affiliates says the way to win in bond investing is to avoid defaults, which is where an active manager's judgment and credit analysis comes in. However, funds that contain a large number of bonds cushion any one bond default. In a strong economy, defaults should not be a problem.
Dividend-Paying Stock Funds
[NC] As discussed under the Observations tab, bonds do not give much income in this time of low interest rates. Investors have been supplementing their bond income with dividend-paying stocks. It was noted recently that rising interest rates puts downward pressure on high-dividend paying stocks as interest on bonds becomes more competitive for income investors. Stocks also raise the portfolio risk, but can be managed with attention and periodic rebalancing. Funds, rather than stocks, provide diversification, as a bad earnings report from a company can affect its stock price significantly.
[NC] The chart below shows the latest three months. The rise from 12/24/18 has been dramatic with the S&P 500 ETF moving up over 16% -- a annualized return of 140%. This cannot go on much longer. This chart shows four dividend ETFs together with a light blue investment-grade corporate bond fund (LQD) and the black S&P 500 SPDRs (SPY) for comparison. Click here for the latest or to add your ETF or stock to the chart. A similar chart for bond funds is below.
[NC] The distribution yield (as of 1/10/2019) and expense ratio are given in the table.
[NC] Bond funds provide a balance to an equity portfolio. Use a bond fund or consider a bond or fund ladder (July
2012 article on pros & cons). Individual bonds would need
to be held to maturity in this rising interest rate
envioronment. Ultra-safe 3-month Treasury bills are yielding over 2.35%
and these could be rolled over every three months to get the next
higher interest rate.
[NC] Bond fund holdings are weighted giving the highest weight to the borrowers that have the largest debt. That would seem to encourage companies to take on more debt, which would not be good when economic activity starts to drop. Also consider floating-rate funds and senior bank loan funds that are described below. These are short-term and thus have little sensitivity to interest rate changes.
[NC] There are three types of risk in the bond market:
Interest rate risk, bond default risk, and liquidity risk. As interest
rates rise, bond prices fall, which could result in a capital loss that
would not be offset by the income stream. The default risk depends
on the quality of the bond as rated: AAA down to below junk
status CCC. Liquidity risk is a measure of the ability of the bond
dealer to buy bonds or sell bonds from his inventory to service the
market. Inventories have been dropping dramatically in the last few
years, as shown below.
This six-month chart shows the recent movement of the total return (interest reinvested)
of various typical bond-type funds is shown below. Click here for the latest. Note measures of risk in the table below.
[NC] The yields to maturity and descriptions below are as of 1/10/2019. The
chart above shows the volatility and impact of changing rates --
demonstrated by the blue 7-10 year Treasury bond fund. Duration
is a measure of the sensitivity of bonds to interest rate
changes. A bond with a 5-year duration will move down 5% if the
market interest rate for the bond increases 1%. Therefore,
short-term bonds are safer than these shown here except for FLOT, SRLN and HYGH.
[NC] The iShares Core US Aggregate Bond ETF (AGG)
with 34.4 billion in assets is the fund has become the standard for
measuring bond fund returns. It yields 2.66% with a duration
of 6.7 years. It's expense ratio is only 0.08%.
[NC] PIMCO Enhanced Short-Maturity ETF (MINT)
is yielding 1.59% with 0.35% annual expenses. It has an average
duration of 0.32 years, and is actively managed by Jerome
Schneider. It's price has been dropping since the end of October 2017.
[NC] Senior bank loans are loans to borrowers that have below investment grade credit ratings. In the event of a default, these bank loans are repaid before other creditors. They are short-term loans and the ETF tends to increase in price when interest rates rise. SPDR Blackstone GSO Senior Loan ETF SRLN yields 4.0% with a 0.70% expense ratio. This ETF provides actively managed exposure to noninvestment-grade, floating-rate senior secured debt of US and non-US corporations that resets in 3 months or less. Current reset is 22 days. Read more here.
[NC] High-yield bonds move more like stocks. The iShares iBoxx High-Yield Corporate Bond fund HYG is a 3-star fund with a yield to maturity of 5.64% and an expense ratio of 0.49%. It's duration is 3.65 years with 74% of holding in the U.S. There is an interest rate hedged fund HYGH, the iShares High Yield Interest Rate Hedged fund. This fund yields 6.01% (5.01% on 6/15/18) with an expense ratio of 0.54%. It's duration is stated to be zero.
[NC] If interest rates go up, bond prices will go down, unless sold at or near maturity. Rates are quite low now -- and the Fed is expected to slowly raise the (short-term) Federal Funds Rate as it has been doing. However, the long-term rates are market driven. An analysis of this chart can be found here. A chart of long-term interest rates back to when the U.S. Constitution was ratified in 1788 is provided by Barron's.
Chart source is given at the top right of the chart. This page is for amusement only, and should not be taken as advice to buy or sell anything.