2018 Fixed Income Comparison And Recommendation

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Includes: BBN, BFZ, GBAB, HYG, LQD, NRZ, TFI, TLT
by: Dividend Investor 101
Summary

It's been a rough start for fixed income so far this year.

Don't expect it to get better, as the FED is planning on raising rates this year.  This could mean capital losses for income producing bonds and Treasuries.

The spread between 2 and 30 year US Treasuries is not very big.  It will be wise to avoid long dated Treasuries this year.

If you are a buy and hold until maturity investor on individual bonds, the trend will work in your favor.

2017 was a great year for the stock market. It also was a decent year for the bond market. Treasuries and preferred stocks performed the best from the fixed income categories selected, as seen below:

Income type: Treasuries 20+ Corporate Bonds Build America Municipal Bonds Junk Bonds Preferred Shares
Ticker: TLT LQD BAB TFI JNK PGX
2017 Return w/ Dividend 10.00% 7.70% 6.16% 5.90% 6.28% 10.15%

Even with rates rising in 2017, the bond market seemed to shrug it off and bonds did slightly opposite what one might expect them to do when rates are rising (Normally with interest rates rising, bond prices would fall and yields would go up).

2018 has not seen this same scenario play out though. It seems that the bond market and fixed income market has finally woken up to the fact that the FED has been and will continue to raise interest rates. US Treasuries have been the worst performer year to date, as seen below:

2018 YTD
Income type: Treasuries 20+ Corporate Bonds Build America Municipal Bonds Junk Bonds Preferred Shares
Ticker: TLT LQD BAB TFI JNK PGX
2018 Return w/ Dividend -6.50% -2.99% -3.4% -1.99% -2.1% -3.49%

With the Federal Reserve planning on hiking rates this year (let's say anywhere from 2-4 hikes, with 3 as the middle ground), it could be a nasty year for fixed income and the bond market. Personally, I am planning on 3 rate hikes this year, which would add 0.75% to the average yield. Plus since bonds and Treasuries rallied in 2017, even when rates were rising, they may need to over correct this year.

So what does the fixed income and bond market look like right now? As of February 8, here is where we stand:

2018 (current)
Income type: Treasuries 20+ Corporate Bonds Build America Municipal Bonds Junk Bonds Preferred Shares
Ticker: TLT LQD BAB TFI JNK PGX
Price (2/03/18) 118.61 117.86 29.66 47.94 35.94 14.34
NAV 118.59 117.92 29.84 48.17 35.99 14.31
Discount to NAV 0% 0% 0% 0% 0% 0%
Current Yield 2.6% 3.2% 4.00% 2.19% 6.17% 5.85%
% AAA bonds 99% 3% 16% 26% 0% 0%
% of AA bonds 0% 8% 55% 74% 0% 2%
% of A bonds 0% 43% 18% 0% 0% 2%
Leverage 0% 0% 0% 0% 0% 0%
WAL duration 26 years 12 years 9 years 7 years 4 years 5 years
Monthly pay rate? Yes Yes Yes Yes Yes Yes

As for other investments, 1 year CD rates are around 1-2% and 5 year CD rates are around 2-3%, depending on if you find a good deal or not. The 2 year US Treasury note stands at 2.10%, the 10 year at 2.83% and the 30 year at 3.11%.

Where to invest in fixed income

With all of the different choices for 2018 to pick from, where should a fixed income investor invest money? With yields starting to creep up, and volatility starting to pick up, the best theme for fixed income investing for those who can't stomach the extreme ups and downs would be short-term investments that you hold until maturity. This could also be a good investment theme for the coming years, if rates continue to rise.

Quite frankly, I think the bond bull market we have experienced for the past few decades is over. With the government looking at a 1 trillion dollar budget deficit for the foreseeable future, yields will have to rise, as investors will be demanding more money because of the greater risk for holding it. This is one of the reasons the stock market has been so volatile lately.

If yields rise, prices will go down, meaning if you have bought into an ETF or other type of product with no maturity, your capital will start to erode. If you are worried about preserving capital, below are some recommendations for those looking to make money while preserving capital.

Short-Term Treasuries

Probably the most interesting thing that I see as I look at the fixed income landscape right now is the spread between 2 and 30 year US Treasuries. The 2 year Treasury is at 2.10% and the 30 year is at 3.11%. That means there is only a 1% difference in yield.

Personally, for preserving capital, I recommend buying short-term Treasuries and holding them until maturity. I would stay away from the longer dated Treasuries (anything 5 years and above) and buy short term Treasuries. For example, one year from now, if the FED raises rates 3 times, the 2 year Treasury yield will probably be 2.9% or so. In 2019, if rates where to go up 2 or 3 times, then the yield on the 2 year note would be around 3.4% to 3.65%. When your 2 year Treasury matures, you will be able to get another 2 year note at a yield higher than the 30 year Treasury note that you are stuck holding until maturity. Or you could buy a longer dated Treasury or bond at that point once the yield is higher.

So, buying short-term treasuries and holding them to maturity would preserve capital, while helping to provide income at around 2% per year.

If you are looking at buying Treasuries through an ETF, be very careful. If rates keep rising over the next decade, you could be looking at a lot of capital losses, which your investment income would not make up for. So an ETF like iShares Barclays 20+ Yr Treasury bond (TLT) will probably not be a good investment over the next year or two, or even longer, as rates rise. If the US ever experience a debt problem and rates rise even more as they spiral out of control, TLT would defiantly be a big loser. It is already down over 6% YTD.

Corporate and Municipal Bonds

The same argument for US Treasuries would also apply to US corporate debt and Municipal bonds. As you look at investments for 2018, I would stay away from ETFs and Closed End Funds (CEFs) that invest in long-term debt, both investment grade and junk bonds. Some examples would be iShares IBoxx Investment Grade Corp Bond Fund (LQD) or iShares iBoxx High Yield Corp Bond (HYG). Municipal Investment funds like SPDR Nuveen Barclays Capital Municipal Bond Fund (TFI) or Blackrock California Municipal Income Trust (BFZ) will also underperform in an environment with rates rising and you will risk capital depreciation that the dividends will not cover.

If you are looking to invest in corporate or municipal bonds, it would be best to invest in bonds issued by the companies or municipalities themselves and hold them to maturity. Again, as with Treasuries, it would be wise to hold short-term bonds, as the coupons are starting to have a better yield, and you don't want to be stuck holding a low yielding bond for the next 30 years while rates are rising. Or you should ladder your investments that you hold to maturity, meaning you don't buy them all at the same time.

Certificates of Deposit (CDs)

I would also recommend short term CDs, because with interest rates rising, you do not want to be stuck in a long-term CD and miss out on better interest rates a year from now. I would suggest a 1 year CD and then roll it over with better interest rates in 2019. Do the same each year as rates keep rising. If rates ever start to level off or go back down, that would be the time to invest in a longer term CD.

What Should You Do With An ETF Or CEF?

If you have bought into EFTs that hold bonds or fixed income, expect 2018 to be a bumpy ride. More likely than not, prices will continue to come down and yields will go up. From the chart above, none of the options look that attractive, especially in the face of rising rates. Also, remember if you are holding any leveraged EFT long-term bond funds, if rates do rise a lot this year and next, those leveraged EFTs will definitely not perform well, as the leverage will exasperate the problem.

Personally, I hold some preferred stock and Build America Bonds. I plan to hold on to them, as I like the fixed income generated at around 8% per year. I can also handle seeing swings up or down on my portfolio and plan on holding them for the long-term. Plus, I do not like to guess which way stocks and bonds are going to go. Even though 2018 has been bad for the fixed income markets so far, things could always turn around...or they could keep going down.

The point is, I have picked income investments that I believe offer a good risk/reward play and I don't sell them unless their fundamentals erode. I currently hold two taxable Build America Bond funds in my IRA: Guggenheim Build America Bonds (GBAB), and BlackRock Build America Bonds (BBN), along with some high-yielding preferred stock in my IRA like Drive Shack (DS-B), Dynex Capital (DX), Colony NorthStar (NYSE:CLNC), and MTGE Investment corp (NASDAQ:MTGE). Because these are investments that yield around 8% to 8.5%, the extra yield helps to compensate for the greater risk, plus they are not taxed because they are in a retirement account. If you are looking at an EFT or CEF to invest in, I still like BBN, which you can read about here. GBAB is also a good fund for those willing to brave a long-term investment in bonds. Keep in mind though, that while these funds produce great current income, they will more than likely depreciate over the next year as the price goes down. So each investor must decide what they are willing to handle and how long they are going to invest in the fund for.

Drive Shack's preferred stock series B (DS-B) is currently yielding 9.5%, which is a fairly large yield, considering they are not in danger of going out of business. If you want to read an article I wrote about the common stock, you can read it here. This may be the best risk/reward preferred stock out there at the moment.

How To Hedge Rising Rates

Since 2018 should be the year of rising rates, as a hedge against rising rates, I am holding a position in New Residential Corp (NYSE:NRZ). It is a REIT that invests in Mortgage Servicing Rights, or MSRs, along with some other investments in mortgages and loans. MSRs increase in value as rates rise and will give off more cash while increasing the book value of NRZ, so this would help to balance out a bond fund that would decrease in value as rates rise. As evidence of how well this strategy works, New Residential has had some great quarters this past year in the face of rising rates. Book value and core earnings both went up. So far this strategy is working well and helping to offset losses in my bond EFTs as rates rise. Plus, it currently yields 12.29%, with the recent market sell off, which is a nice addition to an income portfolio. You can read about it here. I still believe it is at least a $20 stock, and is currently selling for $16.30.

Summary

2018 should be a volatile year for fixed income. The major theme will be trying to preserve capital while producing income. The above ideas will help you find ways to preserve capital while producing income. If you have a week stomach, and can't handle major gyrations in your fixed income portfolio, 2018 will be the year you want to put money into short-term CDs and buy individual short-term bonds and US Treasuries to hold until maturity. That way you do not have to worry about the ups and downs that ETFs will bring with them. You can also look to off set capital losses on bonds funds through an investment in NRZ which should do well as rates rise.

As always, do your own due diligence, and good luck investing.

Disclosure: I am/we are long GBAB, BBN, NRZ, MTGEP, DXPA,DS-B,CLNSPC. 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.