Yields Of 6% To 16%: Markets Freak Out But Patient Investors Can Benefit

by: Mike the PhD

If you don't want to have to sit on your income producing investments for the next few years, it is time to "freak out". The July 5 jobs report was strong enough that, if things keep going as they are, the Fed will likely feel compelled to begin tapering by the end of the year. Unfortunately, for short-term investors in income-oriented investments (either ETFs or high-yielding stocks), the market saw this coming, and institutions have been going nuts selling every income producing asset they can for a couple of months now.

Of course for patient investors, this race from any and all income stocks has created some good opportunities as described in articles here and here.

But as an overall result, if you are still in income-oriented investments, you are now faced with a choice, panic, freak out, and sell immediately with the rest of the markets, or sit patiently, tune out the markets, and wait for the stocks to recover (which they will in a few years).

Anyone investing in mREITs, MLPs, utilities, gold miners, bond CEFs, municipal bonds, and most high-yielding common stocks has been getting crushed recently and the pain is only getting worse. Let's use Annaly (NYSE:NLY) as an example. On Friday, Annaly was crushed by nearly 7% falling to roughly a 7-year low. This despite the fact that the firm only cut its dividend modestly a few weeks earlier (where the market seemed to be expecting a large cut) such that the firm now yields 14%. Analysts have largely abandoned NLY with 16 of 20 now rating it a 'Hold' and 2 rating it a 'Sell.'

It's tempting to believe that NLY will come roaring back in a few months and that investors will get all of their money back quickly; unfortunately that is probably wrong. It will likely take 2-3 years before NLY returns to these levels. In the meantime investors will have to patiently collect their dividends (which will probably be cut a little bit more before this is all done) and wait the stock out. It's either that, or sell now and take a huge loss. That said, I do NOT expect that NLY's dividend will be cut to 0, nor do I expect the firm will go out of business. The firm will adjust to higher rates, but it will take time. Investors' only choice now is to be patient or sell ASAP. Investors should not expect the situation to get better. It probably won't anytime soon.

So, why am I so sure that eventually things will work out OK for these rate-dependent investments in the end; because all of this has happened before, specifically in 1993-1995.

In the early 1990s after cutting rates to extremely low levels to combat a housing-induced recession (the S&L crisis), Fed Chairman Alan Greenspan, began raising rates as the economy picked up steam and interest rate sensitive investments fell apart in 1994.

The problem with trying to assess what happened in the early 1990s for these interest rate sensitive stocks is that most of the companies simply don't go back that far. NLY only goes back to 1998 or so, while MLP old-timer Kinder Morgan Partners (NYSE:KMP) goes back to late 1992, which wasn't enough time for it to be completely impacted by the low rates of the 1991 recession.

Yet one asset class that was around back then, and did experience the whole 1990s real estate bust is municipal bond CEFs. (See my detailed article on muni bond CEF's here for more details and the outlook for muni and fixed income CEFs going forward.)

These CEF's hold fixed-income bonds with long maturities (usually 20 years plus). As a result, they are severely affected by interest rate hikes, particularly because many of these CEFs used short-term leverage to load up on long-term investments. This is about as bad an investment as you can imagine in a rising rate environment right? Yet even here, things ended up working out OK for investors as the table below shows.

Return Year

Share Price







































































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This table shows the mean change in net asset value and in share price for all Nuveen municipal CEFs from 1990 through 2012. (This is representative of the broader fixed income market because Nuveen has a lot of different muni CEFs and munis are a pretty typical bond product). What the table shows is that after large run-ups in Net asset value in 1991 and 1992 (corresponding to rapidly falling rates), net asset values fell more than 10% in 1994. This is exactly analogous to what is going on now; in 2011 and 2012, we saw enormous spikes in NAV, and so far in 2013, we have seen about a 5-7% fall in NAV across most Nuveen CEFs. So 2013 looks a lot like 1994 in many respects. Yet in 1995, NAVs came roaring back along with share prices.

The same pattern occurred in 1999 and 2000, and it is occurring again today with many muni funds at multi-year lows and offering very safe, tax-free yields from 6-9%. (Again see the article I mentioned above for more details on muni opportunities.)

The chart below shows that this pattern is holding even in unleveraged muni funds like Nuveen's (NYSE:NIM).

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The point here is that income-oriented investors should not be expecting an immediate turnaround in their stocks. The pain is going to stay for a while, but eventually these funds, firms, and stocks will adjust to it and their share prices will come back strongly.

Looking at some of these assets only reinforces how large these declines have been, and investors can at least hope that while the stocks may not be about to come back, the declines will slow or stop as rates reach "normal" levels. There is particular hope for those issues that have already seen sharp declines like the mREITs, many of which now trade a multi-year lows as the graphs below show.

For example, this first graph is American Capital (NASDAQ:AGNC) and shows the stock has retreated to a three-year low.

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This is a severe reaction given that several analysts have cited AGNC's actions to protect its book value by shifting to less interest rate sensitive investments. Yet, AGNC's move pales in comparison with Armour's (NYSE:ARR).

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ARR has fallen by nearly half since the start of the year due to its heavy exposure to long-term interest rate sensitive mortgage securities funded with short-term debt. Yet, even ARR still offers hope for investors yielding 20% at this point. This of course assumes that ARR won't cut its dividend, which it probably will, but not by much if analysts covering the stock are to be believed. In fact with a Net Interest Margin of 136 bps as of May (2013), it is likely that ARR will be able to ride-out the interest rate increase cycle and eventually adjust its portfolio to accommodate the new higher rates.

In fact, concerns over interest rate increases have rippled across the entire sector with the sector ETF (NYSEARCA:MORT) falling more than 20% from its highs as the chart below shows. This is very significant because MORT's portfolio includes all of the big names in the sector; NLY, AGNC, (NYSE:CIM), (NYSE:MFA), (NYSE:TWO), (NYSE:HTS), (NYSE:IVR) and more. Thus at these levels, investors in MORT can get a basket of all of these stocks at levels not seen since Europe was threatening to implode a few years ago while simultaneously avoiding the firm-specific risk associated with any given company.

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Now thus far, I have talked a lot about the mREITs and to a lesser extent muni funds, but these assets are certainly not the only ones that have been hurt by the market collapse thus far. In fact, there are a variety of asset classes that offer opportunities at this stage, but only for patient investors. MLPs are one such class.

Lately MLPs have been hit by a double dose of trouble, first by the rising rates, which makes these bond-like investments less attractive, and then second by concerns over their accounting practices in the wake of the Linn Co (LNCO), (LINE) debacle. That said, LINE looks to be a special case to me and I don't think it's reasonable to impugn all of the MLPs based on the accounting irregularities present at one firm. Despite this, markets seem to feel otherwise.

Take the recent performance of another popular MLP lately, CVR Energy (NYSE:CVRR) which owns oil refineries. When the tapering talk started, CVRR fell about 15%, but since the debacle last week, the firm has fallen another 10%+. At these levels, CVRR is yielding nearly 25% in dividends alone! The market is practically guaranteeing that the dividend is unsustainable. In the interest of brevity, I will leave that issue alone for now except to say that currently of the 6 analysts following the stock, 2 rate it a 'buy' and 4 rate it a 'hold'. Notably, none rate it a 'sell' suggesting that analysts aren't worried about the firm collapsing as looks set to do.

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Now it would be one thing if the collapse in MLPs were limited to a few names or even a single area of this broad sector, but it's not. Instead, the entire MLP framework seems to be falling apart as if these infrastructure holding companies will all be gone in a few years. One major ETF in the space (NYSEARCA:YMLP), for example, has fallen 10% from its high and looks like it may be getting ready to repeat its meltdown (and subsequent recovery) of late last year.

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Finally it's worth noting that in all of the chaos surrounding the market meltdown for rate sensitive stocks, there are likely to be some significant number of serious mispricings. Two unrelated stocks, which both seem to me to be seriously undervalued by the markets right now, are preferred stock fund (NYSEMKT:CIK) and theme park operator Six Flags (NYSE:SIX).

Looking first at CIK in the chart below, you can see that the fund has experienced meltdowns and recoveries before. CIK invests in preferred stock and high-yield corporate debt. So it might make sense for the firm to decline in value, except that the corporate debt is mainly short-term paper expiring within five years or so! As a result, while the firm will experience some small degree of loss on its paper as short-term rates rise, the expectation of future increases in short-term rates should be good for the fund as it indicates likely increases in yield. Despite this, the fund has fallen 15% in roughly a month, which seems excess to me given the potential increases in future yield the fund can get if rates rise over time.

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But as crazy as the drop in CIK is, perhaps no stock's behavior of late has been as ludicrous as that of SIX and peer Cedar Fair (NYSE:FUN). To see why, let's first ask a couple of basic questions. Number one; are trips to amusement parks a luxury or a necessity? I would assume for almost everyone they are a luxury. Number two; would you expect people to spend more or less on luxury goods as the economy improves? Again, I would assume nearly everyone would spend more. Given these two facts, I think it's reasonable to infer that as the economy improves, people ought to be spending more money at SIX and FUN's parks… after all when times are good, we all take more vacations.

Yet, SIX has fallen by nearly 10% in the last month as investors worried that the economy will get to be "too good" and the Fed will cut back on its QE. It is hard to come up with a case of greater irrationality on the part of the market then this in my view as the chart below illustrates. Of course, eventually this situation will correct itself and improved profits from SIX and FUN will compel investors to push the stocks' prices up, but until that time, long-term investors will simply have to be patient.

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In summary, investors in income-oriented stocks generally face a tough choice now; endure almost certain short-term pain in the hopes of longer-term recovery in these stocks while collecting dividends, or sell shares now at levels far below where these firms traded a few months ago and forgo future dividends and the eventual recovery of the companies.

Of course, those investors who sell are also faced with a secondary issue… what to do with the cash they raise? There are only a few options here, and none of them look all that appealing; buy non-income oriented stocks which may or may not be richly valued at these levels, buy less rate-sensitive stocks that will still go down, but go down less, or put the money in a mattress and wait a few years forgoing income during that time. Each investor has to make his or her own choice of course, but either way, the market looks set to remain uncomfortable for income investors who don't like volatility.

Disclosure: I am long SIX, FUN, NLY, YMLP, CIK, CVRR. 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.