Income Investors Face Enormous Macro Risks Ahead

by: James A. Kostohryz

With 10-year U.S. Treasury Bonds (^TXN) yielding around 2.0% and yields on a variety of fixed-income investments at or near record lows, many investors have been stretching farther and farther along in the duration and risk spectrum in order to obtain yield. In many cases, former fixed-income investors have even turned to dividend producing stocks in order to meet their income goals.

Income investors need to understand that they are investing in an environment that presents enormous risks to their capital as well as their income in inflation-adjusted terms. Below I would like to highlight and summarize just a few of these risks.

Major Risks

1. Fed-induced inflation. Fed officials have made it clear that they will spare no recourse, including massive “money printing” and “helicopter drops,” in order to prevent depression and associated deflation. Furthermore, it is clear that the Fed will take such extreme measures even at the potential expense of provoking high inflation. If you have any doubts about this, please read what Fed Chairman Bernanke has had to say on this subject.

2. 10Y Treasury Bonds are in an unprecedented bubble. At no time in the history of the U.S. have 10Y Treasury yields been sustained anywhere near 2.0%. And given the fact that the U.S. is on a fiat monetary system, combined with point No. 1 above, it is overwhelmingly likely that 10Y yields will rise very substantially from current levels within the next two years – to 4.0% at a minimum, and well beyond. Please see here and here for a detailed explanation for why long-term Treasury yields are extremely unlikely to be sustained at a level of 2% or lower.
3. All scenarios point to higher yields. As explained here, there is virtually no reasonable scenario in which 10Y yields can be sustained below 2.0%. First, if the U.S. economy recovers, yields will rise toward and beyond 4.0%. Second, if the U.S. economy stagnates or contracts, tax collections will plummet, triggering a fiscal crisis much like that currently being experienced in Italy or Spain – countries whose deficits are ironically much lower than that of the U.S. as a percent of GDP. Just as in the countries cited, heightened default risk would cause U.S. Treasury yields to spike. Third, assuming that the Fed would not allow the U.S. to enter into a default scenario (the most likely scenario), the Fed would be forced to engage in a policy of reducing U.S. debt in real terms through inflation. In either of these scenarios, long-term rates rise.
4. Sensitivity of long-duration assets. If long-term Treasury yields rise, it is virtually inevitable that the value of high-yielding long-duration assets (such as high dividend stocks) will fall precipitously in absolute and/or relative terms compared to alternative asset classes. The value of high yield assets has risen with the bull market in long-term Treasuries. Their value will likely fall in a bear market for long-term Treasuries.
5. Long-duration high yield assets are in a bubble. This bubble is of course a by-product of the long-term Treasury bubble. This bubble may be an absolute value bubble or merely a relative value bubble. The bubble can be observed across many asset classes. For instance, dividend-producing stocks are trading at all time high valuations in terms of PE relative to low yielding growth stocks. Another example may be found in the fact that high dividend producing sectors such as MLPs are trading at historically high valuations in terms of relative distribution yields as well as in relation to metrics such as PE, P/CF and EV/EBITDA.
6. Business risks. First, many equity income investors may be exposed to sectors that are more sensitive to inflation than they realize. Second, increasing long-term interest rates increase the cost of capital and make many previously viable projects economically nonviable. This can kill growth prospects and therefore lower equity valuations. Third, many high yielding stocks such as MLPs are also highly leveraged. Higher interest rates can make current projects unprofitable because the maturity profile of the debt of these companies is not perfectly matched with the life of their projects. Another example of the effects of leverage is provided by high yielding mREITS such as Annaly Capital Management (NYSE:NLY). These companies are extremely vulnerable to rising financing costs and also vulnerable to capital losses in their portfolios incurred due to rising long-term rates and the concomitantly falling prices of long-duration assets. Indeed, their entire business model can be jeopardized by abrupt rate increases at the long and/or short ends of the yield curve and changes in the shape of the yield curve.
But Treasury Yields Are So Low!
When confronted with the fact that many long-duration high-yielding assets are richly valued, many equity income investors retort: “Just look at where Treasury Yields are. Compared to that, my high-yield asset is tremendous value!”
Indeed, the typical response of many income investors sounds a great deal like the retort provided by some technology investors in 1999 that argued that at a PE of 80, their stock was cheap: “Just look at Internet stocks that have PEs of 300 or more!”
The problem with both of these responses is that they are backward-looking. The responses assume that the future will remain like the present. In particular, the responses show that the people uttering them fail to see that the benchmark for value that there are using is inappropriate because of its overvaluation and that this benchmark will not have its current value in the future.
The truth of the matter is that long-term Treasury Bonds (TLT, IEF) are currently in an unsustainable bubble, orchestrated by the Fed that is artificially suppressing rates at the long end of the curve. And this bubble has dragged other long-duration and high yielding assets along with it.
When the long-term Treasury bubble bursts, so will the concomitantly inflated values of other long-duration and high yielding asset classes that many income investors are heavily exposed to.
Absolute yields on most high-yielding investments from corporate bonds (JNK, HYG, PHB) to MLPs such as Embridge Energy Partners (NYSE:EEP), Kinder Morgan Energy Partners (NYSE:KMP) and Enterprise Products Partners (NYSE:EPD) and are at or near historic lows. And relative yields of traditionally high yielding assets are also extremely low versus almost all assets except U.S. Treasuries. For this reason, it is overwhelmingly likely that spreads to Treasuries of traditionally high-yielding investments are not going to shrink through further nominal yield contraction of high-yielding instruments but through yield expansion of Treasuries.
With 10Y bond yields at 2.0% it can be said with a relatively high degree of certainty that the party in high-yielding and long-duration assets will likely be interrupted.
Many high yielding assets have been excellent performers in recent years and are currently serving as a trap that has lured many unsuspecting investors. Performance chasing has not only enticed new investors with bad timing, it has also produced a false sense of complacency and even misplaced loyalty among longer-term holders. Many of these investors will get badly hurt unless they adjust their portfolios accordingly.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am long SPX puts. I am short TLT and long TBT and SBND.