Fed's QE Infinity Will Drive A Flight To Yield

Includes: BND, DOC, ET, MLPA, T, TLT, VNQ, VYM, VZ
by: Jim Kimmelman

Yield chasers will drive up prices.

Bond yields will continue to drop along with CDs.

REITs, MLPs and high yield dividend stocks will stand out.

The Federal Reserve is starting to face pressures from the trade war and it's obsession with preventing markets from any correction. Jerome Powell likely facing political pressure stated:

We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion, with a strong labor market and inflation near our symmetric 2 percent objective.

Powell was appointed by Trump and is likely facing pressure to restart quantitative easing and cutting rates. I believe this is happening because in the short term it will boost the markets and economy. Trump wants this to help his re-election chances.

The Fed likely realizes higher interested will balloon interest on debt payments. 2019 is expected at $383 billion and in 10 years nearly a trillion a year assuming no rate changes. Unless inflation picks up, the Fed could manage low interest rates similar to the Bank of Japan.

I project a drop in interest rates on the 10 year to 1% as the Fed will replace mortgage backed securities with treasuries. The drop in rates will remain higher than most developed economies like Japan or Germany. Long term government debt like (TLT) is a strong short term play as bond prices continue to rise as the rates drop. Short term rates will have to drop as the 10 year currently yields .2% less than the 3 months.

How this will play out into equities? A continued drop will force many to chase yield.

Chart Data by YCharts

Currently, TLT's yield has dropped from 2.8% late last year down to 2.48%. While the overall bond market (BND) has yet to budge due to owning shorter dated bonds. Government debt is already offering .6% less than a high dividend ETF like (VYM). If rates drop further, many income seeking investors will have to move money elsewhere.

A few areas that will fare well in a case of significant rate drops are leveraged high yield such as REITs and MLPs. High yield dividend stocks should also benefit from a yield chase.

Starting with REITs, a low rate environment will allow these companies to convert more to free cash flows as interest expenses drop. This will allow them to further drive growth and increases to dividends. A quality ETF in this sector is Vanguard Real Estate (VNQ) and a stand out in the sector right now is Physicians Realty (DOC)

Physicians Realty is a healthcare REIT that offers a strong dividend with a margin of safety. Why this stands out is because of favorable US demographics. The population is aging and as they do, the amount spent on healthcare rises dramatically. They are also positioning themselves into a fine niche of outpatient medical office buildings.

As you can see there is a dramatic shift to outpatient care. Mostly driven by reduced cost compared to impatient care at a traditional hospital. This trend will likely continue as high deductible insurance plans become more common and people are looking for savings. Physicians Realty is positioned to capitalize on this shift.

Physicians Realty also has a higher than average lease rate and term rate. Currently 95.4% of their properties and at a weighted 7.7 year term. Most of their lease expirations are 7+ years off. Debt is not a concern especially in a declining rate environment. The 5% yield also boast strong coverage at ~120%.

The next sector that benefits from a low rate environment is Master Limited Partnerships. A fund that covers this area is Global X MLP ETF (MLPA). While I have discussed this area and the potential tax drag issues with a MLP fund in this article. This area benefits for two main reasons. Decreasing rates typically helps boast commodity prices. The sector is not as depended on high commodity prices like producers. Higher oil prices do allow them to price their pipeline space at a higher rate. This sector is also capital intensive which like REITs decreased rates allow for lower interest expenses to fund growth. A stand out company in this sector primed for growth is Energy Transfers (ET).

Energy Transfers delivered 39% year over year growth in their most recent quarter. They are a large player in the sector at a $38 billion market cap. Their impressive 8.45% dividend is well covered at 2.07x. They trade below sector average at 9.5x EBITDA.

Even with their impressive growth over the last 3 years. They have several projects listed for completion in 2019 and 2020. They are self-funding $5 billion to drive this. Most of this growth is directed at key areas of US energy growth such as natural gas. This positions them to capitalize on increasing LNG exports primarily through their Lake Charles. This project is a 50/50 partnership with Shell. Energy Transfers is positioned to offer a safe large distribution with growth continuing over the next 2 years.

High dividend stocks are likely to benefit from a low rate environment due to yield chasing. Vanguard High Dividend Yield ETF (VYM) is a good option to gain exposure. A few companies that stand out are Verizon (VZ) and AT&T (T). These companies offer a high dividend with decent safety margins. AT&T carries a large debt burden due to acquisitions. Lower rates will allow them to finance their long term debt and reduce interest expenses. Their dividend is unlikely to grow quickly because of their commitment to reduce leverage. Other companies that are better positioned are ones with lack of exposure to China and Mexico and have a high percentage of sales in the United States.

We are addicted to dovish Federal Reserve policies and will race with the rest of the developed world to lower interest rates. This will continue to drive up asset prices as cheap money does. These areas will likely outpace the overall market due to their strengths with dovish policies. Will we ever see normalized rates and Fed balance sheet? I do not see a way to wean off.

Disclosure: I am/we are long ET, VYM. 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.