Recently, an article by Mr. Gary Golnik argued that interest rate risk did not represent as significant a threat to portfolio valuation and, quite honestly, did some good chartmanship to drive his point. He claimed in the title that he "can endure more bond duration than Chuck". The "Chuck" in this case is Mr. Chuck Carnevale who asked his readers "How Much Bond Duration Could You Endure?" His article argued, described here too briefly in over simplistic terms, that one should avoid bonds and generate income through investment in equities demonstrating dividend growth, and argued that a DGI approach would be more prudent than bonds (which he argued aren't providing enough income, with which I do agree).
It appears that not only can Gary ensure more bond duration than Chuck, but he can endure much more duration than the Owl as well. In order to avoid what I believe is a false choice only between duration ("Gary") and DGI ("Chuck"), I would like to offer the readers a third alternative so that they can secure adequate income while avoiding, or at least reducing, the severity of the capital impairments which will inevitably occur due to the upcoming higher interest rates. I believe that these rate increases will negatively impacting not just intermediate-to-long-term bonds (which is broadly recognized), but also strike the so-called "safe" dividend producing stocks, about which there appears to be significant complacency.
Both of these articles (and resulting comments) were very thoughtful, very respectful of the other author and were very thought-provoking. In fact, they were both so thought-provoking that they have provoked me to write a third article, disagreeing (to some extent) with both and offering a third alternative to their Interest Rate Mitigation strategies. These articles, especially Mr. Golnik's, create a challenge for a discussion about the real risks that investors in long-term debt are taking, with an eye to ensuring that investors understand the risks posed by these securities to their capital position.
Policymakers have driven interest rates to zero (which was originally needed to save the global economy), then have held them in place for nearly 7 years. I agree strongly that at some time low interest rates was desperately needed for healing immediately after the financial crisis and that the immediate steps that Mssrs. Paulson, Bernanke and Geithner took were necessary and saved the economy. However, this policy has long outlasted its usefulness and needs to be altered, significantly and soon. Why is this an issue?
Policymakers have rewarded debtors while punishing those who save, especially "traditional savers" who used "traditional savings tools" like savings accounts, CDs, money market funds and fixed-income vehicles of a variety of maturities (many from federal and state governments). While needed in 2008 and immediately thereafter, it now represents use of monetary tools to address policy failures since 2000 (for balance, this includes all wings of both parties), which the Fed cannot address.
The interest rate policy that we have witnessed is unprecedented for the Fed since its creation a century ago. Even more impressive, the parallel policy in England has delivered such low rates for such an extended time not seen since the late 1600s. As such, bond valuations are at equally unprecedented, high valuations. No modern economy has operated in this regime and now, without the classic toolbox to use, traditional savers need different (hopefully temporary) solutions to cope with an unprecedented investing period as "safe" investments are no longer safe.
"But Owl, what the heck does that have to do with Gary and Chuck", you ask? Well, in this environment with interest rates at historical lows (valuations at historical highs), Mr. Golnik was reaching for a small increment of income by "going long", putting his capital more at risk than perhaps realized by buying at historically high valuations. 10-year rates are not at 5%, as shown in Mr. Golnik's chart, they are at 2.25% and if rates move but 0.5%, that could impair the value by more than 18% on a current yield basis (more if additional rate moves of the underlying bonds are anticipated in the market price). Moving half-way to a "mean" interest rate (approximately) of 4% would imply a near 30% reduction in the value of a nominally "safe" bond. During the term of the 10 year, rates will likely continue to move higher, if history has any relevance to the future, and continue to push bond valuations even lower.
This would lead to capital impairments that one could only recover at or near bond redemption. The good news: yes, you can get your money back if you wait 10 years (for a 10-year bond), having earned sub-par income for that entire 10-year period waiting. The bad news: to get your money back, you will need to wait nearly the full 10 years to recoup your investment, and will have had 10 years (additional to the previous seven) of income impairment. If you are retired and own 30-year bonds, your "safe" bond will likely be impaired throughout your entire retirement and income constrained, with the ability to redeploy that investment only upon taking serious capital losses.
Parenthetically, Prof. Paul Krugman has very famously and openly supported the continuation of the "anti-austerity" policy, supporting continued zero interest rates and, I infer, continued deficit spending (or maybe increased deficit spending). My question is, "Where is the resulting economic activity growth to justify a continuation of this monumentally expensive policy?" More to the point of this article, if you are a traditional saver and have seen essentially zero income for seven years on savings that you had scrimped to create in order to have a more comfortable retirement, would you not consider this policy "austerity"?
So what can a "traditional saver" do to capture decent income while preserving capital? How can you beat this "austerity program for savers"?
What to Avoid:
Savers need to do two things. The first is not to compound historical loss of income with future capital impairment by avoiding certain traps:
1. Avoid debt with long maturities: However low the default risk is on long-maturity debt, there is a high and growing risk of interest-rate risk on this debt that is arguably at 400-year-interest-rate lows. Avoid these securities in all forms or, should you buy it, do so within a portfolio which mitigates or dilutes the upcoming capital impairment (or make a conscious decision that this will not matter to you later).
Avoid Treasuries with maturities greater than 5 years. If you own shorter-term maturities, you will be receiving vanishingly small returns, so best to look elsewhere.
2. Reduce, if not Avoid, Long-maturity Municipal Debt:
Municipals carry a similar interest-rate risk to Treasuries, although due to their higher coupons, they are not as vulnerable to the same degree of capital impairment as Treasuries, given their higher coupons. Having said that, they are still vulnerable.
In addition, there are an increasing number jurisdictions that have increasingly limited ability to support their debt. Puerto Rico, Chicago, Illinois and Connecticut are all being pressed by either high levels of debt relative to revenues or unfunded pension liability or both. Yet other jurisdictions are drifting in this direction. Rising default risk in selected jurisdictions makes purchasing municipal debt just that much riskier and more difficult.
3. Avoid "Perceived Safe" Equities with Income that Have Been Bid Up to Unsafe Levels Because They Are "Safe":
I use this circuitous logic sarcastically, but in truth, while some equities are known to be safe havens and providers of income during economic downturns, some of these classes of securities have been bid up to unsafe levels precisely because of their perceived safety. Selected utilities, telecoms, consumer staple, REITs and healthcare issues are now at valuations well-above historical norms and are vulnerable to reductions in valuations (with REITs already having had something of a correction). While this may not be as prominent a threat as the fixed-income, potential losses in some of these securities are multiples of the incremental income captured from these stocks, and, as such, represent poor risk-reward. How do you know? Ensure that if one is buying equities for the dividend that the earnings multiple and the yield is more in line with historical norms and not significantly higher (based upon your personal risk tolerance) what it has historically been. I am not saying don't own ANY of these securities; however, make sure that you are not paying up to buy safety or because of a high valuation due to low interest rates. The latter is true, but not permanently so, and this premium valuation will melt away as rates increase, leaving you with losses.
For all of these securities, one key point is that the overvaluation of these securities and potential losses are multiples of the income; as such, years of income can be wiped out by capital losses when the market turns. I don't want to lose 8 years of the interest from a 2.25% long-term Treasury lost almost overnight by a commonplace 0.5% move in rates. However, that is what we are looking at, given the amped up valuations for fixed income.
One other item to be considered: the broadcast news talks about the Fed controlling interest rates. Actually, they control the short end of the curve (i.e., short-term rates). The market controls the long rates. What will the market do to long rates when the Fed moves the short rates? Exactly, I am not sure, either.
OK. So what can we do?
Where Should I Focus Income Investment?
The second thing that savers need to do is to generate income while minimizing potential capital losses (a blinding glimpse of the obvious). What tools do savers have to do this?
1. Use Floating Rate Preferred Shares:
There are a number of preferred shares (of TBTF banks) having coupons that "float" or are indexed to LIBOR. As such, as rates rise, the dividend paid on these shares will increase (once the floor has been exceeded). They are currently paying out about 4% (almost double the Treasury 10-year rate) and their valuation will not be impaired due to rising interest rates. They are traded on the exchanges and their prices fluctuate (the bad news), but they are currently trading at 20% discounts to face value, which provides additional security that the valuations will not become significantly impaired.
Here are a few of the issues that I use, have used or could recommend using:
|B of A Series I||BML-G||$19.29||0.75%||3%||3.9|
|B of A Series Ii||BML-H||$19.31||0.65%||3%||4.0|
|Goldman Pf A||GS-A||$19.39||0.75%||3.75%||4.9%|
|Goldman Pf D||GS-D||$19.63||0.67%||4%||5.2%|
|US Bancorp Pf H||USB-H||$22.06||0.6%||3.5%||4%|
|UBS TRLV TRUPS||UBS-D||$18.75||0.7%||0%||1.2%|
For reference, these preferred shares have face value/liquidation value of $25.
A couple of comments about these selections versus other BoA, GS, MS, SAN, and other floating rate bank preferred shares:
a. When short rates begin to rise, there may be some reduction in value as the short rates rise and reduce the spread of preferred floor rate to short rate policy index. That is why I pick the lower floor issues, rather than the other series with higher 4% floors (other than GS-D, see below).
b. By virtue of the current lower floors, these issues have a lower current yield than the 4% floor issues (like other BofA, MS, SAN preferreds), other than GS-D which has a discount similar to the lower floor issues. These 20% discounts (10% for USB-H) should provide some buffer to this effect as the 4% floor issues are trading close to face value (again, except for GS-D).
c. A very interesting share series, of which I know only one broadly traded like it, is the UBS-D which has no floor. This could be used as a cash surrogate and the valuation of this security should respond when the short rate policy benchmark moves. It will yield little now, but should track the increase in short rates.
I have used these preferreds in our family retirement accounts as reliable income providers which should react relatively neutrally to rates (if not positively).
2. Bank Loan Participation Funds:
I am using Loan Participation Funds (i.e.., bank loans) as a second leg on my "Interest Rate Increase Mitigation" portfolio. Yes, there is some default risk, but it has historically been small relative to the appearance of interest rate risk now carried by long-term debt. In addition, while people group these into the "junk bond" category, these loans are senior to the junk bonds, so in a hypothetical liquidation, the value of junk bonds need to be exhausted before the bank loans are impaired, making them less risky, but not riskless.
For these types of securities, I use Closed End Funds (although I have 20% of my 401K in bank loan, open-ended funds as CEFs are not an option in my 401k). CEFs, unlike open-ended funds or ETFs, are not forced to liquidate their holdings on sell-offs, as CEFs do not have redemptions but are simply sold off like stocks. Open-ended funds would need to liquidate bank loans to meet redemptions beyond the cash buffer which they (may) keep in place. ETFs are especially vulnerable to redemptions as one can sell ETFs in an instant, but it takes days or even weeks to liquidate the underlying bank loan. In the event of a sharp selloff, the funds would be forced to liquidate illiquid holdings under duress. As such, I am using CEFs for this purpose and avoid the ETFs as I am concerned about their structure, at least for those securities where disposition of assets requires days or weeks.
In addition, the CEFs are selling at discounts to NAV, providing an additional buffer against valuation declines, and boosts yield on your investment.
I am currently using the BlackRock Floating Rate Income Strategy Fund (NYSE:FRA), but there are a number of good funds run by well-established fund managers (other funds by BlackRock along with Eaton Vance, Nuveen and Voya).
3. Other (High Yielding) Income Instruments like mREITs plus Cash:
mREITs may not feel like an appropriate contribution to a portfolio designed to mitigate risk as one may view them as more, not less risky, than long-term Treasuries. However, the difference is in the risk versus the income generated. For example, AGNC currently offers a 12.9% dividend return, as opposed to the 10-year Treasury at 2.25%.
Given the vastly higher return, one can create a piece of a portfolio combining AGNC with cash, creating a barbell to create a risk-managed approach while still generating higher yield. One could combine 1 part of AGNC with 2 part cash to deliver a "barbell" that still provides a 4.3% yield (assuming a 0% yield for the cash portion) and delivers a duration of about 3 (AGNC Duration about 6-8, let's say 9/3 = 3, 90% more income than the 10-year with 30% of the nominal duration.
One could use other mREITs or the investor may have other, favorite higher yielding securities (BDCs, although they come close to the Loan Participation funds, MLPs) to substitute into this part of the portfolio to provide high yield that can be mitigated with a barbell strategy.
An Portfolio Example:
To provide an illustration about how to assemble a portfolio to cope with upcoming interest rate increases, let's use the tools discussed above to assemble a $100,000 portfolio and contrast it with a 10-Year Treasury Bond at 2.25%.
To do this, I will use two floating rate preferreds (that also provide income about every 7 weeks, providing steady income), two loan participation CEFs, one mREIT (NASDAQ:AGNC) and cash, combined at a ratio of 4:2:1:1.
|Security||# Shares||Price||Investment||Dividend||Income||% Yield|
|PPR||2,000||$ 5.35||$10,700||$0.336||$ 672||6.3%|
Again, this portfolio is about 48% floating rate preferreds, 24% bank loan CEFs, 12% mREITs and the remaining 16% in cash, reducing the overall volatility of the portfolio (and specifically offsetting the mREIT risk while enabling capture of the high income from the mREIT).
So compare this portfolio, having an estimated duration of about 1.1 (AGNC contributes 12% times an estimated 9 duration with the remaining portfolio having a duration near 0 as rates are variable) and more than twice the income, while still having 16% cash to buffer volatility and to use to acquire prices become more attractive.
Now assume that interest rates increase 0.5%, with AGNC dropping 2x the rate of 30-year (assumption) and variable rate preferred shares assumed to drop linearly with the factor of the spread compression of the current yield versus a 0.5% higher short-term rate (0.5/4.0 factor) and loan participation funds not changing as rates variable:
AGNC: $12,116 * 0.36 = $4,362
BML-G & USB-H: $44,520 * 0.5/4.0 = $5,565 loss
Portfolio Reduction = $9,927 or 9.9% of total portfolio value.
10-Year Treasury (current yield basis) = 2.25/2.75 * $100,000 =
$81,818 or a loss of $18,181.
As such, Gary's "go long" 10-year bond would absorb 82% higher losses while delivering 46% of the income of the Interest Rate Mitigation portfolio. Gary can absorb more duration than either Chuck or the Owl, but as you can see, he would regret it.
The purpose of this article was to highlight the risks being taken by "riskless" bonds as well as "safe securities" being bid up to unsafe levels. An additional purpose was to highlight options for investors to use as tools to help protect themselves against likely interest rates increases in the foreseeable future. Since we are currently at one extreme end of distribution curve on interest rates, and therefore, fixed income security valuations, there is a significantly higher probability that rates will begin to rise and valuations on existing instruments to fall than other scenarios.
So is Gary, Chuck or the Owl right? The real answer is all of us and not one of us. As always, truth lies somewhere in the middle of the perception of each. The real utility of this article, and the others, is to identify and employ portfolio tools using concepts from all three articles. Truth be told, I will only now confess that I have incorporated in my investments both equities with consistent growth on dividends (DGI-like) and I have some long-term fixed income, albeit a very small amount, to balance other holdings. Indeed, that is why we have portfolios.
Having said that, we are entering a time at which it will behoove every income investor to have a sizeable portion of their portfolio in securities that will allow each to survive the coming change of interest rate policy. One will not get rich from these investments. Rather, they will provide much needed income and allow the investor to "live to die another day". Preserving capital will enable one to get into the next phase of investing which, if my guess is correct, will provide many more opportunities to buy things at much better prices.
My hope is that I have offered some useful options to income investors to make it into that next period with a steady stream of acceptable income and capital intact.
Disclosure: No guarantees or representations are made. The Owl is not a registered investment advisor and does not provide specific investment advice. The information is for informational purposes only. You should always consult a financial advisor.
Securities prices and data obtained from Yahoo Finance and Barron's (July 27th, 2015 edition).
Disclosure: I am/we are long FRA.
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 also long bml-g, usb-h