Make no mistake, interest rates will rise. While many, including me, have been surprised about how long it is taking, the day will come when investors don't think 3% is fair compensation for lending the U.S. Government money for 30 years or 1.75% for 10 years. If you are worried about rising rates, and you should be even if you don't own bonds, there are steps that you can take to remove risk and possibly add return to your investment portfolio. While what I advise may not help you in 2013, I also think that the cost of my recommendations is likely low.
Why are Rates So Low
Interest rates are low for a very simple reason: Demand. Before I examine the sources of demand, though, let's take a look. Here is the chart of the benchmark U.S. Ten-year Treasury Note:
Let me take a moment here, as perhaps it's not clear how low rates are and what really drives interest rates. This history goes back to the early 1960s. The red line represents the 10-year Treasury, while the green line is Nominal GDP (Real GDP plus inflation). The blue shadings represent recessions, when real economic growth is negative.
During the post WW-II and post-Vietnam era, our economy was chugging, but so was inflation as the era progressed. Note that Nominal GDP growth trended higher (though with recessions) until very high interest rates thanks to Fed Chairman Volcker in the early 80s changed the story: We got inflation under control. Since then, Nominal GDP has trended lower. In the first recession of the 21st century, Nominal GDP hit zero. In the Great Recession, it plunged, the only time Nominal GDP was negative for more than a quarter (Nominal GDP only once was negative in a single quarter).
Notice that interest rates have generally tracked Nominal GDP. This is what I was taught in college, and it has remained true for the past 25 years or so. This wasn't a normal recession, and it isn't a normal recovery. We shouldn't be surprised that interest rates have remained low. In each of the past several recessions dating to 1991, the Treasury yields have continued to fall after the recession had ended. Don't confuse cyclical and secular trends - it's the latter that drove this.
So, to the question, why are rates so low? Why is there such demand for bonds? Demographics. Fear. Manipulation. Complacency. I don't intend to dive deeply into each of these. You are going to be with me on this or not. On the first point, the aging of our society has led to a reduction in risk-tolerance as people approach the end of their income-generation and beginning of their portfolio draw-down. This leads to my second point: The crash of 2008-2009 woke people up regarding asset allocation and caused them to swing too far towards risk-aversion. The manipulation by the Federal Reserve, which has been buying Treasuries and Mortgages and promising the world that low rates will stay, has led to artificially low rates. Finally, investors have continued to buy bonds, becoming complacent to the risks, perhaps because of implied promises from Chairman Bernanke.
Two Radically Different Paths to Higher Rates
Let me get the variant views out of the way. First, if we are Japan, headed for years of economic malaise or worse, then quit reading now. Everything that follows will prove to be bad advice. I don't believe that's our fate, but I have no crystal ball. My goal here is to share my views on how to structure portfolios if rates do rise. With that out of the way, let me share a huge caveat: Rising rates aren't like roses. Rather, there's the path of returning economic normalcy (which is what I am anticipating and would smell good like a rose) and an Armageddon situation where we turn into Greece in terms of controlling our own economic fate. If the latter is what you think I mean by rising rates, then you should also disregard everything that follows. In this scenario, sell everything. Buy guns and canned goods.
The path I anticipate of returning economic normalcy will lead to abandonment of a great number of fixed-income investments subject to loss of capital. While many think that rising rates are inherently bad for stocks, this isn't always the case and likely won't be, at least initially. Why? If rates are rising because the economy is improving, then the "E" in PE is going to rise in most cases. Given that we trade well below where one would expect the market to trade on a PE basis given how low interest rates are, the market PE ratio could actually rise at the same time as interest rates begin to rise. Of course, there are limits. At some point, higher interest rates would choke off economic growth. We are likely so far from that point that it doesn't merit discussion. Not with Nominal GDP at 5% in the most recent quarter (but expected to be lower in the year ahead) and the 10-year Treasury below 2%.
So, if you are with me and think that rates could rise as the economy normalizes, you need to realize that the change will likely impact securities you own. While it could have impacts on other classes, I will share my thoughts on bonds and then stocks. As far as other asset classes, I think that the scenario I describe could be good for hard assets - real estate, gold, timber, etc.
What to Do with your Bonds
I will keep the bond advice very simple. This used to be my world (1986-1998), but I am not so close to it any longer that I should be trying to use a microscope. There are three major ways to define differences between bonds: Maturity, Credit and Optionality.
Maturity is easy to understand. Very short-dated bonds, with near-term maturities, have little price risk compared to longer-dated bonds. A 30-year bond's price will fall 15% or more (depending on its coupon and its yield-to-maturity - here is a calculator) if its yield rises by 1%. A one-year bond won't fall at all - it will mature. This is why one usually gets a higher yield, all things equal, for a longer maturity. Advice: Shorten maturity!
Credit involves likelihood of default. The worse the credit, the higher the likelihood and, typically, the higher the return. In the rallying economy we are discussing, bonds with lower credit and higher initial yields are likely to cushion the impact of rising interest rates. Corporate bonds are divided into "investment grade" and "high yield." The best proxy for the overall bond market is the Barclay's Aggregate Bond index. Two ETFs: iShares (NYSEARCA:AGG) and Vanguard (NYSEARCA:BND). This index includes only investment grade Corporates and no high yield. There are two high yield ETFs that are very popular: iShares BOXX High Yield (NYSEARCA:HYG) and SPDR High Yield (NYSEARCA:JNK). Advice: Consider lower quality.
Optionality refers to the fact that many bonds have embedded options. In Corporates, this is less the case than it used to be, but buying bonds that are callable (and getting paid extra) can pay off in a gradually rising interest-rate environment. In a steep sell-off, this can lead to a larger price drop than one might expect potentially, so be sure to work through various scenarios. Where options abound are in the mortgage market, and this is what I am really addressing. Mortgages allow the borrower to prepay at his or her option. If you own the mortgage, you can lose it when rates fall (the homeowner refinances). On the other hand, it can turn into a very long-term investment if the owner takes all 30 years to pay it off. The most common ETF for Mortgages is iShares Barclays Mortgage (NYSEARCA:MBB). In a moderately rising interest rate environment, MBB works well: The higher yield will more than offset the maturity risk. If rates rise a lot, though, it could underperform in total return. If one is very bearish on rates, this is an area to avoid. My advice: Take the yield (but be vigilant).
Barclays publishes data on various bond indices on a daily basis. Here are some current figures:
- Overall Aggregate Index: 1.77% Yield-to-worst, 5.06 Modified Adjusted Duration (a measure of price risk)
- Treasury: 0.89% and 5.44
- Credit: 2.60% and 7.04
- Mortgage: 2.26% and 3.16
- High Yield: 6.06% and 4.14
My overall advice is to shorten maturities. Own very few (if any) Treasuries, limit Corporates to 7 year maturities, emphasize mortgages for now (but be cautious if rates look like they may rise more than 200 bps or we start to see a lot of new home purchases) and consider High-Yield. To the extent one is worried about rates moving sharply higher and the Fed raising short-term rates soon, consider owning cash. Also, one can invest in floating rate securities as well (in Corporates, High-Yield and Mortgages).
What to do with Your Stocks
The overriding theme: If it looks like a bond, it will act like a bond. Many investors have moved into stocks to generate income that can't be found in bonds. The main alternatives include Utilities, REITs, MLPs, BDCs, High-Dividend stocks and Growth-Dividend Stocks. When looking at income-producing stocks in a rising-rate environment, one must be less concerned with maximizing income in the near-term than the long-term. In other words, don't look at yield today, which is the dividend divided by the current stock price. Instead, focus on the growth potential of the dividend. If it can't grow, then you are stuck with a bond-like security. Unless the yield is enough, it will decline in price.
I start with Utilities (NYSEARCA:XLU) because this has long been an alternative to bonds. While Utilities have pulled back after the election due to concerns of tax-law changes (qualified dividend tax-rate), they would be more vulnerable than other securities in my view because of their inability to grow the dividend significantly. With the pullback, this advice is less relevant today than when I warned a few months ago. Still, if one is going to pick individual stocks, consider trading some yield for some growth potential.
REITs don't pay qualifying dividends, so risk of higher taxes doesn't exist. In a recovering economy, the underlying rents and property values should lift. REITs fundamentally work, though many, including me, would suggest to be careful, as the sector has performed pretty well. Again, consider not maximizing yield but rather focusing on growth potential. Finally, keep in mind that REITs must issue debt to grow, so rising rates can impact the financials negatively.
MLPs don't pay qualifying dividends. They don't pay dividends at all: They pay distributions. MLPs always face the risk that they lose their ability to pass through their income without paying taxes, and these fears have certainly been stirred up again. I have no idea how that plays out, but just that very potential suggests not overdoing it in the sector. Not all MLPs are equal - some have very strong distribution growth - they tend to have lower yields but will likely perform better in a rising-rate environment. Like REITs, MLPs must issue debt to grow, so rising rates can impact the financials negatively.
I got a question on BDCs recently, and I want to say a year after suggesting this neat little sector (Business Development Companies, for those not familiar), I continue to like the sector. Some of the better names that I highlighted late last year (here is the last one - it contains links to the prior ones) have done quite well. These are High-Yield surrogates in my view and are probably a good investment (at the right price) in a period of economic growth with moderately rising interest rates. Most importantly, NEVER PAY MORE THAN 1.1X Book Value.
When it comes to real high-yielders, please be careful. They often have a lot of debt and could get squeezed from higher borrowing costs. Plus, often the yield appears high but it is actually low relative to the risks, boosted by hungry yield-chasers.
Dividend Growth Stocks continue to be the place. The yields are typically low (1.5-3%), but this isn't so low compared to the overall bond market. For valuation, I like to compare the inverse of the PE ratios (also known as earnings yield) to long-term corporate bonds, and these have higher base yields on that basis. So, compared to a portfolio of bonds, these guys have a similar yield but the ability to grow income. My advice: Trade out of high-yielders into dividend growth stocks.
Finally, I want to throw out a few ideas. First, consider gold miners. Whether it's the individual stocks or the ETF Market Vectors Gold Miners (NYSEARCA:GDX), these stocks have tracked stocks for the past 5 years and underperformed this year despite a big rise in gold since 2007 and a slight rise in 2012. Many pay dividends now, some linked explicitly to gold prices, and should perform well in the environment I envision. Second, I think that Emerging Markets (NYSEARCA:VWO) should do well. Our economy improving is a real boon for them, and I think that they are in a position where they haven't been too easy with monetary policy and won't need to raise rates. I recently shared my thinking on the sector. Finally, Financials (NYSEARCA:XLF) are leading the way this year, but rising rates could push the rally further. Why? Loan demand and a steeper yield curve (assuming short-rates lag longer-term rates).
One last idea merits its own paragraph, and I include this for those who really need the income and don't want to shift from bonds to stocks or who can't bear to part with slow-growing high-yielding stocks in favor of ones that can grow the dividend faster than rates rise: Sell call options. This isn't my area of expertise, but a conservative buy-write program seems appropriate for this environment, especially if income generation is a primary or important goal. One can even use some of the premium to buy protection (puts) if capital preservation is a primary goal as well.
How I am Playing It
I run three model portfolios at Invest By Model: Top 20, Conservative Growth/Balanced and Sector Selector ETF. The first is a bottom-up portfolio designed to beat the S&P 500 with individual stocks. The last is also designed to beat the S&P 500, but with ETFs. I will share my complete holdings on 1/1, as I have done for several years, but let me share the basic positioning today:
- Top 20 is more slanted towards smaller and growth-oriented holdings
- SSETF has big exposure to Small-Caps, Emerging Market Equities, Gold Miners and Financials
In CG/B, I continue to have minimal exposure to bonds. The "rules" require me to hold at least 10%, and that's about all I have. Further, this exposure is 100% in MBB. We have been nearly maxed out on equities all year (75% is max), so we carry a lot of cash. With AGG yielding something like 2%, the drag of 15% cash is just 0.3% or so per year. Hopefully, I make that up with the overweight in stocks (I think all are raising their dividends), which in my model actually yield about 2.8% on a weighted basis. The stocks? No Utilities. Strong balance sheets. Diversified by economic sector. You can check it out now (with a free 30-day look), or you can wait until I share it publicly on Seeking Alpha in a few days.
Stocks are cheap by many measures. If the economy is going to grow at higher-than-expected rates, they are likely to rally and interest rates are likely to rise. It's too simple to just say "sell bonds and buy stocks." Some bonds will perform worse than others, and some stocks will perform better than others. Hopefully I have shared some ways for you to reposition for 2013 in the event you share my optimism.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: MBB, XLF and VWO are owned in one or more model portfolios managed by the author at Invest By Model