In my last article, I embarked upon a portfolio design to achieve future returns that might exceed those in Pacific Investment Management's (Pimco's) "New Normal" forecast. Pimco chieftains Bill Gross and Mohamed El-Erian anticipate just 4%-6% nominal annual returns for stocks for virtually the rest of our lives, a number that is considerably below the roughly 10% (6.6% inflation-adjusted) average annual return that investors have enjoyed over the past century.
Given Pimco's dim prospect for stocks, I proffered that an opportunity to best its 6% ceiling might begin with corporate bonds. I therefore identified 25 bonds, rated BBB- or better, that would be held for various maturities up to 25 years. That group, held in equal parts, would produce a real return of only 3.4% (based on Aug. 24 prices), not much better than Pimco's 3% inflation-adjusted forecast for stocks.
I considered whether there was anything we might do to boost the prospective return, without scraping the bottom of the bond-quality barrel. I came up with this yield-enhancing idea: Add some mortgage real estate investment trusts (mREITs). I'm obviously a believer in mREITs, which make up nearly 45% of my Covestor model portfolio.
Let's select three mREITs on the basis of their performance and/or management characteristics.
American Capital Agency (NASDAQ:AGNC) has, in my view, become the bluest of the blue-chip mREITs. Its one-year total return (through Sept. 11) is 44.28% vs. 27.01% for the S&P 500 Index. It yields 14.4%.
But the attraction of mREITs does not lie with their total returns alone, but also with their relatively stable price patterns. For example, the beta coefficient of AGNC is 0.42, meaning that it is 58% less volatile than the market.
CYS Investments (NYSE:CYS) has a one-year total return of 28.27% and a yield of 13.8%. Its beta is 0.52%, which makes it 48% less volatile than the market.
Annaly Capital Management (NYSE:NLY) is the venerable name that comes to mind when many people think about mREITs, mostly because of the reputation it earned from its deft management during the recent financial crisis. NLY's total return hasn't been overly impressive recently, but it retains the same management and yields 12.6%. And it is a whopping 74% less volatile than the market.
A 40% allocation to these three mREITs would drive the portfolio's notional yield to worst up to 9.11%. (Of course, the yields for the mREITs would have to remain constant for that return to consistently happen, and they're not going to do that. But for the sake of illustration, we'll pretend that those yields would last indefinitely.) That's a real return of more than 6%, accounting for Pimco's 3% inflation assumption.
Therefore, here's what the portfolio would look like:
Would this specific formula serve us well for the duration of the New Normal? Don't count on it. While a relatively passive investing approach isn't always unreasonable, exceedingly passive investing always is. Adjustments need to be made along the way. Yes, mREITs have been throwing off double-digit total returns over the past few years, but that doesn't mean they always will. An investor will have to review and perhaps update any investment portfolio from time to time. This theoretical portfolio is no different.
And mREITs do add uncertainty and volatility to the mix. Although the bonds have known yields to maturity and will, barring an unlikely default, return that promised yield, mREITs operate like leveraged bond funds that, of course, have no such return guarantees. The boost that mREITs provide today to the portfolio's return is subject to a host of variables that could alter their contribution in the future.
Therefore, it's not necessarily a static portfolio to be held for the duration of the New Normal, but rather an example of what an investor might consider for at least the first part of it.
The author is long certain bonds of SunAmerica, Jefferies Group, Hartford Life, Alcoa, Genworth Financial and Morgan Stanley. Also, the hypothetical model discussed in this article does not represent actual trading and may not reflect the impact of material economic and market factors might have on the adviser's decision-making if the adviser were actually managing clients' money.
Disclosure: I am long JEF, AA, GEN, MS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am not long the stocks of the 4 companies disclosed...I simply own certain of their bonds.