Desperately Seeking Yield Through Equities Redux: Part 10 - The Issue Of Context

by: Philip Mause

This article is part of a series on equity securities which provide the investor attractive opportunities to obtain yield. The first article dealt with BDCs, the second with agency mortgage REITs, the third with non-agency mortgage REITs, the fourth with telecom stocks, the fifth with equity REITs, the sixth with utility stocks, the seventh with tobacco stocks, the eighth with MLPs and the ninth focused on dividend anticipation strategy.

This article will try to put these investments in context. It is my general theory that there is no investment which is inherently "good" or "bad" - it all depends on the price. An investor's decision to invest in one of the sectors described in this series has to be at least partly informed by its comparative attractiveness, taking bond prices and equity prices into account. Recently, there have been some strategists suggesting a retreat to cash and that is another comparison which must be made. When I addressed this issue nearly two years ago in the parallel article in the original series, the S&P 500 was at 1345 and I indicated that "regular" stocks were probably comparatively attractive at least at current price levels. Things have changed quite a bit since then. With both bonds and stocks priced at relatively high levels and cash returning nothing, the sectors described in this series are, I believe, relatively attractive.

I think many investors find these sectors attractive but are concerned about the twin dangers of higher interest rates and a deflationary recession. Because many stocks described in this series may be priced on a dividend yield basis, the interest rate concern is a reasonable one. Many of these companies borrow at floating rates or have to refinance debt periodically. In some cases, they also hold debt instruments as assets and could be forced to write down their portfolio as interest rates increase.

A deflationary recession could also have an adverse effect on many of these companies by increasing defaults on debt instruments they hold as assets, decreasing gross revenue due to reduced economic activity and leading to a forced liquidation driving stock prices down.

Fortunately, we have just been through two test runs on both of these risks. Starting in June, 2004 and ending in August 2006, the Federal Reserve raised the Federal Funds rate from 1.00% to 5.25%. Then, starting in late 2007 and running into March 2009, we had one of the worst sell-offs in history combined with the steepest decline in nominal GDP since the Depression. So, we don't really have to speculate about how these sectors perform with rising interest rates or in a recession; we should just be able to go back and look.

Unfortunately, it is not quite as simple as it sounds. I have tried to put together some numbers which give investors insight into this issue but there are many other ways to do it. Before getting into that, let me describe what I have done. For Annaly Capital (NYSE:NLY) (an agency mortgage REIT), NorthStar Financial (NRF) (a non-agency mortgage REIT), AT&T (NYSE:T), Reynolds America (NYSE:RAI), Kinder Morgan Energy (NYSE:KMP) (an MLP), Ares Capital (NASDAQ:ARCC) (a BDC), the SPDR Dow Jones REIT (NYSEARCA:RWR) and the Dow Utilities Index, the table below provides month end prices for June 2004 (just as the rate increases were beginning), August 2006 (just after the last increase), October 2007 (as the market was peaking) and March 2009 (the bottom of the Crash). The price and dividend information is derived from Yahoo Finance and corporate websites.

6/04 8/04 10/07 3/09
NLY $16.96 $12.51 $17.09 $13.87
NRF $8.78 $11.99 $9.35 $2.32
T $24.25 $31.13 $41.79 $25.20
RAI $67.59 $65.07 $64.43 $35.84
KMP $40.69 $44.77 $52.50 $46.72
ARCC $15.15 $17.79 $16.64 $4.84
RWR $51.63 $81.27 $81.96 $26.39
Dow Utilities $277.89 $442.55 $534.95 $329.37

The RWR numbers are split adjusted. The first column for NRF and ARCC is from October 2004, earlier data is not available because of the date they went public. I have used some indices but in other cases I did not find an index which I considered appropriate. Another problem with an index is that the mix of companies may be constantly changing and the newbies may cloud what we are really trying to discover - how a company fares through an entire cycle. RWR appears to include only equity REITs and avoid the problems of a REIT-wide index which would include mortgage REITS but it includes only a subset of equity REITs. I tried to find companies that have been in existence long enough to go through both cycles and that was a bit difficult because there have been many, many new BDCs, mortgage REITs, etc. formed since 2004 and some of the old players (e.g., Allied Capital) have either been taken over or disbanded. RAI was chosen in the tobacco group because it was not involved in a spin off during the relevant time period.

The dividend story is interesting. NLY's dividend was cut from 48 cents a quarter to 10 cents a quarter during the 2004-06 interest rate run up but held up well during the Crash declining from 55 cents to 50 cents and bouncing back to 75 cents at the end of 2009. NRF's dividend was cut during the Crash from 36 cents a quarter to 10 cents a quarter. RAI and KMP seem to have increased their dividends through both periods of travail. RWR's dividends were cut by almost 50% in the Crash. The utilities did better and generally followed a pattern of very slow but steady dividend increases even through the recession. T did not cut its dividend in either of the time periods; instead, dividends have been steadily increasing.

A couple of patterns emerge. It appears that NLY (and the agency mortgage REIT sector in general) can handle a Crash relatively well but that a rapid rise in interest rates presents challenges. In fact, agency mortgage REITs seem to be the only group that did really badly during the period of rising interest rates. Oddly enough, NLY bounced back nicely by late 2007 and although its price took a hit in the Crash, dividends held up pretty well. KMP has done remarkably well during both periods and probably deserves the Timex award ("takes a licking, keeps on ticking"). It appears that equity REITs and non-agency mortgage REITs can take a beating during a Crash combined with a recession. BDCs also face serious problems (many companies in the industry fared much worse than ARCC).

Since 2008, I have almost always considered a deflationary recession to be a worse risk than rising interest rates for several reasons. I have generally considered it to be more likely because slack in the economy continues to suppress inflation and hold employment down and the Fed is unlikely to raise interest rates under these circumstances. On the other hand, there are a number of "event risks" hovering over us, any one of which could be the shock that would push us back into recession. I am also concerned that a recession could emerge quickly and with little warning whereas increasing interest rates would probably come only after warnings from the Fed and would be gradual if they emerged. I am thus probably more inclined to seek protection from the risk of a deflationary recession than from the risk of rising rates.

I think that the table above suggests that a careful investor can put together a portfolio of stocks in these sectors which produce much more yield than cash or most bond strategies and still protect himself reasonably well from the twin dangers described above. History seems to suggest that such a strategy would emphasize agency mortgage REITs and MLPs but would also include the other sectors to achieve diversity and provide upside if we enter a period of rising rates.

As advised two years ago, I would not advocate putting all of one's assets in these sectors and I believe general equity markets can keep moving up at least as long as there are healthy dividend increases. On the other hand, many of these sectors are likely to do much better than anything in the bond market and several of the sectors have now demonstrated that they can weather a Crash and a severe recession relatively well. Instead of sitting in cash and pining for higher interest rates, yield oriented investors should investigate these sectors and start to move in, always with caution.

Disclosure: I am long T, ARCC, NRF, NLY. 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.

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