Finding Yield In A Rising Rate Environment

by: David Cretcher

Summary

The Fed is on a tightening cycle.

No one can predict long-term rate trends.

Look for investments with asymmetric payouts.

There is a chorus singing that the great bull market in bonds is over. Interest rates have declined steadily since September of 1981. The line of reasoning is that this is long enough.

The specter of an improving economy and a more hawkish Fed will conspire to stop this bull once and for all.

This is an Old Story

Various experts have been calling for this end for at least the last six years. Here's an article from 2010. Back then, Bill Gross, who knows more about these matters than me, made a big bet that the US Treasuries would go up. They were at 3.5 percent at the time.

He believed that the monetary and fiscal stimulus would create inflation, and the rising inflation would drive down bond prices. It didn't. Instead, the economy slowed and there was no inflation. The speculation was wrong.

He wasn't calling for a full stop to the bull market. But the point is that even the experts get interest rates wrong. The truth is that no one really knows what the interest rates or bond prices will do.

It's true we don't know what they will do. But we do know what they can do. Here are some possible scenarios.

Rates Start to Rise

The warnings could be right. Interest rates could increase, and we could start to climb back to what the experts often call "normal rate levels" or the "natural rate."

If this happens, the mathematics of bond yields will engage and the intra maturity value of bonds would collapse. So that's a risk.

Or We Could Be Japan

Another scenario is we could become like Japan, and interest rates will just stay low forever.

Japanese ten-year treasuries have been below two percent since 1998 - that's 20 years. There have been so many speculators betting wrong on this reversing that it is known as the "Widowmaker Trade." So interest rates could stay flat for another twenty years or more.

Or We Could Be Switzerland

It's possible that interest rates won't just stay flat but instead will go negative like they have in Switzerland. This would make bonds an excellent investment, as the lower interest rate would drive bond prices higher.

Or Maybe We Don't Know

The last possibility is the most distasteful. Maybe we don't know. Maybe we can't predict this. Maybe any of the above could come true.

If we accept that we can't predict what will happen, then what will we do? What is the best course of action for the investor?

Understand That You Are Speculating

No matter your action, you're probably speculating to one degree or another. If you are selling bonds because you believe interest rates are rising, you are speculating that rates are rising.

When he made his now infamous bet, Mr. Gross was speculating that inflation was rising. When it didn't rise, he lost his bet. Remember, no one is immune from losing a bet.

The Cost of Waiting

All decisions have costs. If you go to cash, and you are wrong, then you lose the interest you would have been paid in a bond. Nothing is free.

If you had jumped out of bonds and into short-term bonds seven years ago, you would have lost seven years of interest payments. At five percent, that's a cumulative loss of nearly 30 percent over the short rate. It's significant.

Accept the Coupon

In environments where you feel damned if you do and damned if you don't, investors should accept the coupon. Accept that the bond's coupon is going to be your total return. The upside of the bond investment is that you get your money back with interest.

If you hear commentators telling you that Treasuries are a bad investment, remember that held to maturity, no one has lost a dime on a U.S. Treasury. They always got what was promised - their money back with interest. If you're OK with that, live with it.

Look for Asymmetric Payouts

Seek out fixed income that pays a good current rate, but is less interest sensitive. High-coupon premium bonds are one place to look. They provide a cushion if rates rise, but also give you a current coupon. You may lose some on the bond price, but it will be cushioned by the high dividend. You make money in down and flat markets and breakeven in all but a violent up market.

Another place is callable preferred stocks. Here is a chart back to 2006 for GDV preferred series D (GDV-PD), an investment grade preferred stock with a six percent dividend. It is issued by a closed-end mutual fund (NYSE:GDV) and collateralized by fund assets.

(Courtesy of Big Charts)

Here is a graph of fed fund rates during that time. Compare the two graphs and notice the relative price immunity as interest rates dropped from 5.25 percent to 0.25 percent. It is likely, the price will not change much if the rate goes back to five percent.

A number of factors like a high dividend and call-ability combine to make this preferred less sensitive to interest rate changes.

Seeking out investments like these can allow an investor to collect a steady high dividend with less risk to interest rate movements. If rates rise, decline or stay flat, the investor can book a steady dividend.

Discounted for dividends, your investment would have looked like this. You could have done worse.

(Courtesy of StockCharts)

Risks

Panics - As documented in the chart, these securities are sensitive to panic selloffs like the 2008-2009, but the dividend remained intact.

Illiquidity - The other risk is illiquidity. Large orders can trigger large movements in price of the stock. Notice the small tick marks in figure. Trade these securities with limit orders, or find an advisor that understands this asset class.

Credit Risk - There is also credit risk. There is always a chance you won't get your dividend or your money back. This is small with an investment grade security, but it is always a possibility. So watch your position sizes. There is also the chance of a credit downgrade, which may devalue the stock.

Call Risk - Last, there is call risk. Because the stock pays above market interest rate, there is a risk that the issue will be called. Then you will get the par value of 25 dollars and the accrued dividend. If this happens, it will lower your effective yield. If it happens quickly after you buy in, it can result in a loss. So be careful about your entry price.

Conclusion

Accept that no one knows where interest rates are going. Look for asymmetry. Avoid short-term debt that doesn't pay strong dividends now. You will lose in down and flat markets. Find securities that behave well in increasing interest environments; then you can gain in flat, down, and gentle up markets.

Disclosure: I am/we are long GDV-PD.

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: This article is for informational and discussion purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. All investment and speculations have risk. I am not your investment advisor, please consult your financial and tax advisers before investing.

About this article:

Expand
Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here