Conflicting information abounds in the market these days, which means volatility, particularly when it concerns the expectation in the direction in interest rates. Even though the Federal Reserve has forecasted it will purchase Treasuries at a pace of $85B a month for the remainder of this year, rates churned significantly higher in the month of May. This was in a month when the actual need for new U.S. Treasury financing of debt was very low relative to recent years as the new tax law has pushed money into Federal coffers and Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) have been paying some large dividends to the government. So you would think since there is not much new supply on the market, and the Fed has an arsenal with which to make purchases, rates would at least remain where they began the month of May, possibly even move down. Wrong.
Here is a chart of the term structure of interest rates for the month of May:
The movement in interest rates reverberated through the markets. Investments particularly hard hit were those which are most demanded by income investors - public utilities, REITs, mortgage REITs, BDCs, and high dividend paying large cap stocks, particularly those in the telecom sector. Typically when you see the utility and telecom sector sell-off after a large market run-up, it is a sign of the end of a business cycle and possible recession. In this market of central bank driven market valuations, however, I will withhold that judgment for the intermediate term. The data right now point to the confluence of several different factors which are at work to continue to drive rates higher - Excessive Bond Duration because of Low Interest Rates, Re-Treat of Safe-Haven Treasury Buys from Overseas, and the on-going Currency War, particularly with Japan and China.
Prospects of Poor Expected Return on High Duration Government Bonds
When I examine the current investment environment, one of the reasons I see in the data causing many investors to pack up and leave the U.S. Treasury market is that it is just a bad place to put money relative to other opportunities. This was not the case 5 years ago, but it definitely is the case where rates are today, as seen in the graphic below:
The graph shows the carnage in the Treasury complex in May. The longest duration government bonds over the 30-day period lost 6.96% in investment value, while the S&P 500 gained 2.36%. For the year, the differential in returns is even greater. And the return differential is not contained to the long bond; the sell-off was painful all the way down to the 10 year on the yield curve, and losses were felt across all maturities.
On the other hand, investors holding the Treasuries which were purchased 5 years ago in 2008 as the financial crisis began to heat up are sitting on gains that are in excess of the return of the private market as measured by the S&P, well in excess when the yield is included. However, if you do the simple math, the only way this will be the case 5 years from now is if interest rates are at the level they are now, and the stock market CAGR is less than difference between the dividend yield and the interest rate on the Treasuries. In the case of the 10-year Treasury, this means you would have to be expecting the stock market is actually going to be worth less than it is now 5 years from now.
The only other way that Treasuries continue to outperform is that rates go even lower or the stock market drops again like it did in 2008, which could happen in an out-right deflationary scenario. But at the moment, and for the intermediate term, the incentive for an investor who examines the odds of this trade and sees the change in the value of their interest sensitive portfolio holdings, and the prospects of more pain, the Treasury investment on the long-end of the yield curve just looks like a bad buy. With investment banks like Goldman Sachs piling on with calls for the 10 year to move up another 34 basis point to 2.5% by year-end 2013 (Goldman Sachs Rate Call), investors who have been sitting on the gains should be actively reviewing the prospects of the likelihood of losing 20% of principal over the next 5 years for a yield of 1.67%, versus re-deploying some portion of their Treasury portfolio in alternative opportunities.
Foreign Fund Flows - Something is Happening
What else is causing rates to rise? It is not enough to look at the current interest rate environment from the perspective of what is happening only in the U.S. If that were the case, the rate structure would probably get back under control fairly quickly as the Fed begins to initiate a rate pegging policy to control a rapid rise in U.S. Treasury rates - which is the intended plan once the QE policy is reduced in size. However, there have been major changes going on in the international financial markets which most investors have read about in the headlines. The most recent changes I point to are the stabilization of the European crisis with the resolution of the Cyprus crisis in May 2013 and the Japanese stimulus plan, some are calling "Abenomics," which was announced in April 2013.
Since these changes have been announced, investors have witnessed a different investment market than the one that has been in place since the financial crisis of 2008. In order to get an understanding of what is happening, I have been tracking the flow of funds into and out of U.S. Treasuries by foreign buyers for signals. It is well known that foreign holders of Treasuries are at an all-time high of publicly traded U.S. debt - 48.3% as of March 2013 (latest available data). With the Fed holding 15.6%, this leaves only 36.1% held by U.S. private investors, most of which are institutions which are mandated to hold the debt for risk management reasons such as money market funds and insurance companies.
With this level of skewed ownership of the U.S. government debt, it is easy to see how any unwinding of positions by foreigners will lead to a quick rise in interest rates. The data since the height of the financial crisis does show slowing momentum in the pace of the build-up of U.S. Treasuries by foreign buyers, and that run-off has been met with Fed buying (QE1, QE2 and QE3). However, since the latest resolution in the European crisis, I have sensed a much stronger sell-off in the U.S. Treasury market. The data is not yet available for April and May, but some big player is selling, and I do not think it is only U.S. institutions - they are already at an all-time low for ownership.
The most likely seller is foreign-based holders in European countries in my opinion, as holders reverse safe-haven trades. But it could be anywhere, the effect is the same. If a safe haven sell-off is underway, then the Fed may not have an arsenal big enough to stop the market driven rise in rates on the long end of the curve. It will also show up as a strengthening of the dollar as the selling raises interest rates in the U.S. relative to other countries in the world. Recently, the dollar index (DXY) is generally performing in line with what would be expected.
Currency Wars Impact - Changing the Game Pressuring Rates Higher
The third contributing factor in the movement in Treasury rates up despite the Fed QE3 buying program can be found buried in the currency inflows into U.S. Treasuries by foreigners relative to the available supply of Treasuries publicly traded. In the graph below, the Dollar Index is shown in blue, and a line which shows the 12-month moving average of Treasury purchases by foreign purchasers is shown in red. Over the past 20 years, the inverse correlation between these two metrics is very high. The issuance of U.S. debt over this time period has changed depending on the fiscal situation. In the time period from 1999-2000, the fiscal policy was in balance and foreign inflows slowed dramatically - and the dollar increased in strength. The period from 2000-2008 on the other hand saw a dramatic increase in inflows from foreign purchasers - some of which can be traced to increases in Treasury issuance to cover war-time deficits during the time period. But also in play was the increasing use of foreign government purchases of U.S. securities by foreign governments to weaken their currency relative to the dollar. In a sense, it was a trade to finance the U.S. government actions to support population consumption, a large part of which was Asian imported goods.
The above graph shows the trend starting in 2002 of increasing Treasury purchases on a relative basis by foreign investors to finance U.S. deficits worked to weaken the U.S. dollar (to China's advantage which pegs to the dollar). And this cycle continued until it completely broke down in 2008. From that point forward until recently, the inverse relationship of Treasury purchases and dollar strength and weakness has been inverted - positively correlated - which is not the normal pattern.
This reversal back to the more normal trading patterns, however, is now returning in the numbers. This can be traced to multiple factors which are reversing from the patterns during the financial crisis: Safe-haven investments in U.S. Treasuries are in the process of being sold off, the carry-trade in Japan is being turned back on; and, as these events are happening, the U.S. government fiscal policy is tightening, and the need increasingly high levels of debt issuance is declining. When this is combined with a QE withdrawal scenario that is up-coming, you end up in a scenario very similar to either 1994-95, or 2004-2005, with respect to the expected change in foreign inflows and the directional move in interest rates after prolonged easing timeframe and the move up in the dollar.
Almost as a policy to assure the U.S. will remain off the addictive path of low cost foreign government financing to increase government spending, Jack Lew on May 10th was in the headlines (Lew: Vigilance Needed On Stimulus - WSJ) pushing foreign countries to stay within the bounds of international agreements when it comes to using domestic government stimulus programs to weaken their currencies. From a policy standpoint, this will lower demand for U.S. Treasuries, increasing interest rates. But these countries will probably not be deterred entirely from flowing capital into the U.S. to influence their currency. The increasing level of company acquisitions by China, as witnessed by the takeover of Nexen by CNOOC (CEO) (CNOOC Acquires Nexen) and the bid for Smithfield Foods (SFD) and Japan's SoftBank (OTCPK:SFTBF) pending acquisition of Sprint Nextel (S) are likely to continue as these countries look for ways to flow capital into the U.S. by means other than the scrutinized path of buying U.S. Treasuries.
Income Investing Strategy in a Rising Rate Market
The data all point to interest rates continuing to rise over the remainder of 2013 and then continuing into 2014. I liken the situation for the Federal Reserve as not having enough fingers to plug the holes being created in the dam. Interest sensitive sectors will continue to take the brunt of the pain with the progression of the re-balancing.
To assess the current situation, I have reviewed the impact over the prior 30 days on the sectors of the market ETFs (MORT) (VPU) (VNQ) (LAG) (BKLN) (DLN) (AMLP) that are the favorites of the income investor and shown them in the following graph:
I have shown the sectors relative to the performance of the S&P 500 (SPY). I have also included two additional sectors - Banking (KBE) and Insurance (KIE), as companies within these sectors have balance sheets that are structured to allow them to do better from an earnings standpoint as rates rise.
Three of the sectors, Mortgage, REIT and Utilities all went down in value in correlation with the 20-30 year Treasury bond. Corporate bonds did poorly, but most likely due to shorter duration in the fund, were less impacted. Senior leveraged loans held up in the May rate decline, with a relatively short duration as well as loans in the portfolio that will adjust upwards if rates rise. The large cap dividend and MLP ETFs held up the best.
Given this data, and under the assumption that we are at the start, not the completion of the rise in rates, here are my thoughts on available strategies for income investors:
- Financial ETFs - Banks in particular are likely to outperform in the coming months. The underperformance over the past five years in the ETF reflects there is still room to rise. The yield on the group as a whole is not very attractive, and within the index there are some banks that have run-up much quicker than others. My personal pick remains (BAC) and (BBT). Income investors historically have been attracted to the preferred stocks offered by the banks over the common. The most recent new issues are high duration near-equity securities with very low rates - do not dive in at the present time.
- MLPs - As a group, MLPs will remain a sound place to invest in a rising rate environment for taxable portfolios seeking yield. However, within the group, there is a large variance of winners and losers over the last 30 days. It is time to become more selective in your strategy. Highly leveraged MLPs will suffer as rates rise. Much of the prospects for continued high performance will depend on whether the strengthening of the dollar will be deflationary for commodities - if so, the sector will underperform as rates rise. I would avoid the high flying momentum plays at the present time.
- Large Cap Dividend Stocks - As a group, these stocks survived the first round of the move up in rates, and I expect this to continue. Sectors within this group, however, are being negatively impacted by rate increases, particularly companies like AT&T (T) and Verizon (VZ) which are highly leveraged. My preference is to augment the aggregate ETF in this case with potential upside winners in the pharmaceutical [GlaxoSmithKline (GSK)] and energy sector [BP (BP)] as well as maintain an over exposure to the tobacco industry [Altria Group (MO)].
- Utilities - The utility sector as an aggregate and on an individual stock basis at the present time should be sold on a bounce until the dividend rates hit 5% or higher. Normally I would advise movement into the longer-term debt, but as with the new issues of preferred stock by the banks, the long-term subordinated debt by many of the utilities has unreasonably long durations and low rates. The market price of these new issues showed significant relative weakness even in this first wave up in Treasury rates, signaling they will weaken as rates continue to rise.
- Senior Loans - The strategy of using the leverage loan sector as a hedge as rates rise is sound on paper, but comes with several hidden risks. The performance of the Blackstone ETF shows a relative outperformer as rates rise. A lot of the performance is going to be dependent on the quality of the portfolio held by the funds in this sector. Loan structuring and pricing have been extremely aggressive in this sector over the past year. I have reviewed several BDCs in this sector in recent articles on Fifth Street Finance (FSC), PennantPark Investment (PNNT), Prospect Capital (PSEC) and across the board the portfolio quality was shown to be under pressure. The worst offense in this sector is combining the sub debt, 2nd lien and first lien loan into one loan, and calling it a first lien loan - and pricing it as a first lien loan. These are similar abuses as found in the mortgage securitization industry in 2006-07. The best strategy now is do a lot of due diligence on fund content and invest only in un-leveraged ETFs.
- REITs and Mortgage REITs - In general these sectors are going to take hits in any rate movement up because of the memories of 2008. Within each sector, however, there are good investment opportunities which will withstand the initial rounds of rate moves up. The biggest decliners last month were higher quality larger cap REITs whose price levels are too elevated and the current yield was pushed down toward 3%. It is probably best to start looking at augmenting the index strategies in this sector, and also looking at the preferred stock offered by many of the small cap REITs. In the Mortgage REIT sector, selective investing is the only option in my opinion. My only pick at this time is MFA Financial (MFA), including the preferred offering (MFA.B). MFA survived the financial crisis, has a well managed portfolio, and a good track record on managing industry risk.
Your thoughtful comments are appreciated. I am always looking for good ideas.