Here we are again near the Dow Jones Industrial Average's (NYSEARCA:DIA) all-time high. I believe it is a good time to take a step back and gain perspective.
The current Dow Jones Industrial Average level may not be equal to that of 2007, as illustrated by underlying factors. In order to pull the market up the Fed has pushed rates down.
This may give investors even less of a reason to go into treasuries or Corp. bonds. In this article you will see the bigger picture in terms of interest rates, the inflation rate, and the Dow.
I will also describe a simple way to design a multi-mechanism income generating position. This example is based on higher-yield bonds (banking, insurance, foreign government, and university bonds.) In order to comprehensively understand the strategy I will walk through three important considerations.
- Economic instability
- Overall direction
Economic Instability: Banks and Insurance Companies
Take a look at American International Group (NYSE:AIG) and Citigroup (NYSE:C), compared to Assurant (NYSE:AIZ). The example portfolio will use an Assurant bond though I am very skeptical of banks and insurance companies:
The chart leaves very little to be appreciated. The market cap. comparison is completely different (though this means nothing to shareholders who lost 90%). Here I have included Goldman Sachs (NYSE:GS):
- AIG current market cap. $60B
- Citigroup current market cap. $101B
- Assurant current market cap. $3B
Because of AIG and Citi's performance I have disdain for the sectors.
Taxes are important to consider because they contribute greatly to the nation's revenue.
Let's also look at Luxembourg, France and Italy's inflation rate, debt, and taxes, since the example will use European Investment Bank bonds, AXA Group (OTCQX:AXAHY) Corp. bonds and Italy government bonds.
France has been able to keep inflation in check compared to Italy, based on the chart above. Now look at the nation's tax revenue compared to central government debt.
Luxembourg only has 517,000 people, France has 64.4 million and Italy has a 60.6 million population. Moody's rates Luxembourg debt at Aaa with a stable outlook, while France is rated Aaa, with a negative outlook. Italy is rated Baa2 with a negative outlook.
Overall Direction: Interest, Inflation & the Dow Jones
Realistically speaking US rates will move up and down in the next few years. On October 1, 2012 Ben Bernanke reiterated that rates would remain low:
The Committee currently anticipates... low rates of resource utilization and a subdued outlook for inflation... are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
This chart will remind you what it looks like when interest rates slide to historic lows:
Notice that in 2007 the 20-year rate was around 5%, now the rate is 2.4%. A thousand US dollars at 5% will make 100% (before taxes) in 20 years, while $1,000 at 2.4% won't make 100% in 40 years.
Check out the 20-year treasury rate compared to the rate of inflation:
Now for the interesting part, in my opinion. The rate and Dow level on the y-axis do not correspond directly. However, I find their indirect correlation to be noteworthy:
In perspective the historic performance of the Dow occurred while the inflation rate meandered. Notice that inflation rose slightly and precipitated very large downfalls after 2000. The rise of the Dow can only be described as hyper-growth.
A comparison between the movement of the Dow and that of iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) adds to a comprehensive understanding of where we are today:
Now consider the 30-year treasury yield since 1980 relative to inflation and the Dow:
Since 1980 the Dow Jones has gone up and the 30-year treasury bond yield has trended down. Rising inflation during the 50% drop in the Dow was terminated, and the return to the current market level was re-achieved, though I believe it is partly artificial and certainly unpredictable.
Quality & Yield: Multiple Mechanism Income Generation
With proper allocation, a scenario whereby bonds get 'crushed,' as some alarmists warn, may not adversely effect a multi-mechanism income generating strategy. The key is simple, allocation size. Each investor must decide how much, if any, to allocate to fixed income.
One strategy to consider is multiple forms of income production:
- Fixed Income Mutual Funds
- Income Producing Close Ended Funds
Rather than one set of mutual funds, one set of bonds and one set of CEFs, investors could consider a mix of each. Consider one bond, one mutual fund and one CEF as part of a layered position.
It is important to keep in mind slight movements in the interest rate, upwards, will have a great negative result on the bond's price. Take a look at some higher yield bonds, and higher rated bonds, currently on the secondary market.:
|Axa Sa $ Subordinated* Nt 8.6% 2030 (Foreign Bond) (cusip: 054536AA5) call protected, sinking fund protection||A3/BBB+||125.00||6.23%|
|Assurant Inc Sr Nt 6.75000% 2034 (cusip: 04621XAD0) call protected, sinking fund protection||Baa2/BBB||113.75||5.63%|
|Italy Rep Nt 5.375% 2033 (Foreign Bond) (cusip: 465410BG2) call protected, sinking fund protection||NR/-**||97.13||5.61%|
|Goldman Sach Grp Inc MTN Be Fr 6% 2041 Survivor Option Monthly Coupon (cusip: 38141EX95) call protected, sinking fund protection||A3/A-||108.05||5.44%|
|Italy Rep Deb 6.875% 2023 (Foreign Bond) (cusip: 465410AH1) call protected, sinking fund protection||Baa2/-||113.60||5.22%|
|European Invt Bk Glbl Nt 4.875% 2036 (Foreign Bond) (cusip: 298785DV5) call protected, sinking fund protection||Aaa/AAA||121.60||3.51%|
|Stanford Leland Jr Univ Board Fr 4.013% 2042 (cusip: 854403AD4) not call protected, sinking fund protection||Aaa/AAA||107.55||3.59%|
*Subordinated bonds are the last bonds to be paid (and often would not be repaid) if a company defaults. **Moody's rates Italy Baa2 however these bonds are listed without a rating.
- AXA Group (CS.PA):
AXA Group is a French insurance company. The company's annual report shows solid net income of $4.3B euros in 2011; up from $2.7B in 2010.
The new French president, François Hollande, has proposed many changes to the nation's tax system. This includes:
...hikes in taxation on dividend income and reductions in the tax deductibility of interest payments.
Notice Assurant's performance compared to Axa:
Axa did not fall as hard, though Assurant's rebound has been greater than Axa's.
On July 13, 2012 Moody's downgraded Italy's debt to Baa2 from A3. The most recent U.S. Italy tax treaty states:
Interest: Reduces the general withholding tax rate on interest from 15% to 10% and expands the categories of interest income exempt from source-state withholding tax.
A recent Seeking Alpha article, Why Italy's Isn't in Such Bad Shape, makes a favorable case for Italy based on public sector deficit data relative to structural fiscal gap (% of GDP.)
- Goldman Sachs:
While AIG and Citigroup have recovered slightly, Goldman's stock was not hit as hard.
On June 21, 2012 Moody's downgraded Goldman to A3 from A1 and maintained a negative credit outlook. This is a reason to be cautious on Goldman Sachs corporate bonds.
- European Investment Bank:
The European Investment bank is rated Aaa and is based out of Luxembourg.
Moody's Investors Service says that the EIB's Aaa/stable and Prime-1 ratings are based on the institution's very high intrinsic financial strength as well the very high level of support from its highly rated shareholders.
- Stanford University:
Though the Stanford bonds are callable they represent quality in this example. The Stanford Corp. bonds yield around 20% more than the 30-yr. US treasuries. (The most recent 30-yr treasury yield is 2.96%.)
This example contains three layered positions, each have one mutual fund, one CEF and two bonds. I will show an example for a $100,000 portfolio and $1M portfolio. This example is designed for an IRA (Individual Retirement Account):
|Assurant 6.75% 2034 / Goldman Sachs 6% 2041||Income CEF||Fixed Income Mutual Fund (mostly equity)||total / %|
|$100k||$1,200 / $2,200||$500||$2,500||$6,400 / 6.4%|
|$1M||$2,400 / $5,500||$750||$3,500||$12,150 / 1.2%|
|portfolio size||Axa 8.6% 2030 / Italy 6.875% 2023||Income CEF||Fixed Income Mutual Fund (stocks & bonds)||total / %|
|$100k||$1,300 / $2,400||$300||$2,000||$6,000 / 6%|
|$1M||$2,600 / $6,000||$500||$2,500||$11,600 / 1.1%|
American & European Bonds
|portfolio size||EIB 4.875% 2036 / Stanford 4.013% 2042||Income CEF||Fixed Income Mutual Fund (mostly bonds)||total / %|
|$100k||$1,275 / $1,150||$250||$1,750||$4,425 / 4.4%|
|$1M||$2,550 / $3,450||$500||$2,500||$9,000 / 0.9%|
You can see the great difference in allocation size between the two portfolios. These three positions would total 16.6% of the $100k portfolio. The three positions only total 3.2% of the larger portfolio.
Like any bond the greatest risk that applies is the company could default. The hope is that, because of the multiple mechanisms, one element could falter and the other components have the potential to compensate (though there is no guarantee.)
The compounding effect of inflation, uncertainty regarding interest rates, and the level of the Dow Jones Industrial makes it important to generate income and use it with purpose. Though I tend to avoid banks and insurance companies, it is important to consider income generation; for any direction the Dow goes in.
This is not a recommendation to buy or sell, it is important to consult a financial advisor. If you have any thoughts or questions pertaining to Assurant and Axa or this multi-mechanism income generating strategy leave a comment below.
Disclosure: I am long C. 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.
Additional disclosure: I am long Goldman Sachs Corp. bonds. I am considering Stanford University bonds.