Nearly four years into the Fed's ZIRP (zero interest rate policy), attractive yield opportunities are much harder to come by. Many junk bond funds like the Barclays High Yield fund (JNK) and iShares Corporate High Yield Bond fund (HYG) have enjoyed excellent returns over the past few years while rewarding investors with 6-7% yields. With an 11% return from the iShares Preferred ETF (PFF), equating to more than an 18% total return, the secret on that one is out too.
2012 was a difficult year for income investors relying on utilities equities, as the sector was the worst performer in the S&P 500. Some traditional income-producing, blue chip tech stocks like Intel (INTC) and Microsoft (MSFT) also struggled. After strong equity gains, yields on other blue chips like Wal-Mart (WMT) and Coca-Cola (KO) aren't quite as attractive as some income investors may be looking for.
In order to acquire income producing securities in 2013 that provide above average yields without sacrificing quality (risk of capital return), we are going to have to look in some less crowded areas of the marketplace, and we're going to need to have a variant view of beaten-down securities.
Of course, this may not be as relevant for diligent investors with stellar portfolios filled with dividend growth stocks acquired at attractive prices and/or various fixed income securities purchased at attractive yields. Those who are looking for new income opportunities reliant on yield will, however, have an exceptionally difficult time finding what they're looking for without sacrificing quality.
Corporate Yields No Longer Reflect Sufficient Risk Premiums
While there are various exciting offerings in the land of distressed debt, it's my guess that most readers here at SA are looking for investment grade securities with attractive yields.
In the week following "resolution" of the fiscal cliff, yields on the 10-year note rose to over 1.90%. Undeterred by the rise in treasury yields, junk-bond indexes like JNK rose to 52-week highs as individual high yield bonds traded higher.
As it has become increasingly difficult to find meaningful yield in shorter dated bonds, fund managers and ETFs have taken on far more duration risk. Morningstar reports that the holdings in the iBoxx corporate bond ETF (LQD) have an average duration of 7.8 years, meaning a mere 1% rise in interest rates would result in nearly an 8% loss. Given the current 3.83% yield of the ETF, this 1% rise would wipe out more than two years of yield.
The following is a quote from Seth Klarman:
"These days, however, I don't believe investors are being compensated sufficiently to venture beyond risk-free instruments. Yield spreads between government bonds and corporate credits have contracted sharply this year from levels a year ago. Some bonds of such highly leveraged issuers are Burlington Industries and Unisys now trade above par. A year ago they sold at substantial discounts from par"
As you may have guessed from the examples Klarman uses, this quote wasn't made recently, but rather in 1992. The full quote is available here, courtesy of the Distressed Debt Investing Blog.
The similarities in the market and sentiment that Klarman describes are eerily similar to today's realities.
Sprint (S) Capital's 8.75% note due 2032 (CUSIP: 852060AT9) is now trading at 123.67 with a yield of 6.57%.
I'd argue that buying the debt of Sprint, a company with $20 billion in long-term debt, a string of yearly losses, and a dead brand at 23 cents above par is a rather strange investment given Telecom opportunities on the equity side. Verizon (VZ) has only $30 billion in long-term debt vs. at least $15 billion in consistent annual free cash flow, pays a 4.8% dividend, has solid growth prospects and trades at a reasonable multiple.
Sprint is just one example of a lesser-quality issue whose yield no longer offers a compelling rate of return given both duration risk and risk of capital loss.
Reaching For Yield Via Common And Preferred Equity
"Yield hogs," as Seth Klarman put it, have driven up the valuations of many of the blue-chip dividend payers to significant premiums versus the broader market.
Altria (MO), sporting a 5.3% dividend and perceived as a "defensive" stock is trading at more than 18 times earnings vs. a 5-year average P/E of 11. Procter & Gamble (PG), a company whose phase of rapid growth is definitely behind it, trades at 23 times earnings, an enormous premium to the S&P 500 (SPY) multiple of 16.7.
Given these two company's growth prospects, I believe the equity components of the stocks will produce terribly sub-par results over the next several years. Stocks like MO and PG, slower growers perceived as being relatively safe from economic turmoil, do not deserve ultra-premium valuations simply because they offer difficult to find yield.
Investing in expensive stocks for the long term just to be comforted by safety and a dividend yield is a practice that will unquestionably yield disappointing results.
Looking at preferred equity, good luck finding any compelling securities. Long gone are the days of buying financial preferred stock at 12 cents on the dollar with annualized yields in the double digits. Those opportunities were rapidly scooped up by distressed equity investors buying dollars for cents. As previously mentioned, the PFF ETF generated a total return of 18% in 2012, and a look at individual securities shows the difficulty of finding strong investments. Most of the preferreds that offer exceptional yields have an odd feature hidden in the terms, or the company has a junk-grade credit status.
People have begun comparing buying bonds at today's prices to buying stocks at 30 times earnings. I think this is a fair comparison. You've got a lot of smart people saying bonds offer "return-free risk," and it's become awfully difficult to argue against that.
On a near-term basis, we can rationalize negative real rates on Treasuries (and barely real after-tax rates on most corporate bonds) with the typical arguments: European worries, tons of liquidity, risk of financial catastrophe etc.
Over time, however, many bonds and bond funds are ticking time bombs. "Winding up" these time bombs are the increased duration risk funds are taking to maintain attractive yields.
While everyone obviously has different time frames and investment goals, the average investor should be avoiding securities that have surged in value as a result of the flight to safety and income dynamic. Positioning your portfolio for 2013 with bond ETFs like JNK and LQD or individual, longer-dated securities just to earn some incremental yield is a tremendously concave strategy and is analogous to speculation in common stocks.
In Part 2 I'll discuss securities that haven't been bid up to inflated levels as a result of the income they generate, and that still offer attractive return profiles.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.