When Real Yields Are Negative, Try Foreign Currency and Be Patient

 |  Includes: IDU, UTH, VPU, XLU
by: Roger Nusbaum

A reader asks the following;

Most U.S. interest rates are now below the current rate of inflation, i.e. we have negative real yields. I know you often speak of what the text book says, but does it say anything about what is the usual best of action in this situation of negative real yields, with particular reference to income? Do you go with shorter maturities? Longer? Shun utilities? Overweight gold/commodities etc.?

There is a lot there to try to work through. I may have been interviewed on Monday about this topic (not sure if the brevity of the email exchange constitutes an interview) and so I'll expand on those answers.

The current state of yields is problematic if you have cash earmarked for fixed income, as I do, as a couple client holdings have matured or been called away. Locking in less than 4% for five or ten years seems like a very bad idea (I am not really looking to buying fixed income for a trade). The short version of this post would simply be that I think the best thing for most folks is to just be patient.

I think it is unlikely that yields stay unacceptably low for a long time, but I have to say that, Nicole Elliott's warning notwithstanding, I did not expect the 10-year to go so low in yield. A few years ago yields were too low. I waited, and eventually there was a window for a few months where 2-year treasuries yielded 5-5.25% and so I was lucky to pick up some yield then. Yields will go up at some point.

To the reader's question of shorter maturities, the two year is yielding about 2% and the five year is a little under 3%. Assuming you are not looking for a trade, do you feel compelled to lock in those kinds of yields? You are probably getting better in your money market. So, again, just wait.

You are probably aware that parts of the muni market have been yielding more than the treasury market, not doing the calculation for your tax rate, but straight up yielding more (at least some of them). That is compelling in a way for taxable accounts, but there is some sort of message there. If some issues have problems keeping their AAA rating as a function of what happens with the insurers - I am aware of the recent news but nothing would shock me - they could be a tough hold.

Obviously a rating downgrade due to losing insurance won't make the issue any more likely to default, but could do some nasty things to the price between now and maturity.

The reader asks about shunning utilities. I would not shun them, no. Generally they held up much better than the market during the first couple of weeks in January, and generally have been market performers for the last three months, but the yield has obviously been better. Bespoke had a table of average returns sector by sector during bear markets, and utilities dropped what I believe was about 21-22% versus about 30% for the SPX. However when yields start to go back, it makes sense to expect utilities to lag. There is some history to support this.

I would avoid heavy closed end fund exposure here. I'm not a fan of heavy exposure to CEFs in general, but when rates do go up some CEFs will get pasted. Owning a couple of CEFs is OK if that happens, but if you go heavy, you will very likely have some ugly results where you were expecting stability.

What about floating rate funds you may ask? Sometimes they work as advertised and sometimes they don't. You are relying on the market to not create a wider discount, and the market does not always oblige.

One area where I have had some luck is with foreign bonds, which I have written about before. These are tough to access due to order size restrictions, but the liquidity for foreign sovereign debt seems to be pretty good. Within my ownership universe is two year paper (a little shorter than that now) from Norway, Australia and Great Britain.

Each of the countries are different and so the blend makes for good diversification, in my opinion. GB is struggling but the yield is pretty good, Oz is a high yielding commodity currency with deficits and Norway is a commodity currency with surpluses (my YTM here is in the mid fours and the currency gain has been huge since I bought).

I'm not hoping for a lot from the currency exposure but the yield is better. If you can find exposure, it might be a good thing for a small portion, but again going heavy in CEFs in this space has the same problems.

The WisdomTree currency ETFs could solve the problem as I believe they will hold short term debt from the underlying countries. Hopefully they will go ahead and list them all, the funds are successful and then they expand the product line.

Lastly a link. Mike Shedlock had a great post a couple of months ago that will be very helpful.