Co-produced with PendragonY
In today's report, we'll begin with an overview of the financial environment and how banks will be the beneficiaries of a widening interest rate spread. Then we provide a detailed report on a CEF investment in the banking and financial sector. We'll see how John Hancock Financial Opportunity Fund (NYSE:BTO) can hedge our portfolio against inflation and higher long-term interest rates.
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After months of downplaying inflation fears as temporary, the Federal Reserve chair Jerome Powell finally acknowledges that this inflation could turn out to be higher and more persistent than they expected.
We have been seeing signs of inflation for several months now. Fueled by government stimulus packages, a record $2 trillion surge in cash hit the deposit accounts of U.S. banks since the coronavirus first struck the U.S. in January 2020 (source: FDIC data). Excess cash is a significant cause of inflation.
As COVID-19 restrictions ease worldwide, the economy continues to recover, wages are rising, and supply chain disruptions improve. Due to pent-up demand, consumers tend to become less price-sensitive, allowing businesses to raise prices. Look around at McDonald's (MCD) and KFC (YUM) paring back $5-and-under items in favor of more expensive $10-$30 meal combos to tackle rising food costs, lift sales, and improve profit margins. Mr. Buffett warned us about this several weeks ago.
We are seeing very substantial inflation. It's very interesting. We are raising prices. People are raising prices to us and it's being accepted - Warren Buffett
These are classic signs of inflation, and it is imperative to remember that inflation is a lagging indicator that peaks long after an expansion in economic activity has ended.
Inflation is like the brown spot on a banana, by the time you see it, it's way too late - Benjamin Tal, CIBC Deputy Chief Economist.
The U.S. inflation rate is at its highest level in over a decade.
According to a recent report from the Wall Street Journal dated May 20, 2021 (even before the recent 5.4% inflation report), households' expectations for inflation in the coming 12 months have shot up to 4.6%, according to the University of Michigan's consumer survey. This is dangerous, meaning that inflation is anchored today and that most likely the recent increase in everyday household and food prices is likely to be irreversible.
We have been warning our readers and followers about the perils of the upcoming inflation for many months now. Continued record-low interest rates mean your money isn't growing adequately, and rising prices mean you are facing higher expenses. The Fed projected that there would be two rate hikes in 2023, which may be too late to curb inflation, and the damage to your portfolio could hurt both the value of your portfolio, your income, and your lifestyle.
The Fed's Dilemma
The Fed is in a tough spot at the moment. Ideally, to contain inflation, they should raise rates. But, for many reasons, they cannot do that.
- Firstly, this recovering economy is still fragile and could crumble without the continued availability of low-cost financing. Increasing interest rates at this time would likely result in a return to recession.
- Secondly, given that several other entities (government and the financial section) are pouring cash into the economy, it would probably take a massive hike in interest rates to contain the inflation.
The Fed could slow down (or even end) the buying of bonds. Since March 2020, the Fed has bought $982 billion of the mortgage bonds and currently plans to keep buying at least $40 billion each month along with the monthly purchases of $80 billion of Treasury debt. During the June 15-16 policy meeting, the Fed reaffirmed plans to continue holding short-term interest rates near zero and continue the asset purchases for some time. Nor did the FOMC meeting at the end of July indicate any changes.
The last time the Fed abruptly changed such a policy, we had the Taper Tantrum. The Fed is not eager to repeat that, and so this $120 billion a month of cash infusion is unlikely to slow down before the end of summer.
So, how will all of this impact interest rates? The market has a lot to do with interest rates, and inflation expectations are critical to those rates. With the Fed keeping the short end of the rate curve nailed down near zero, the rate curve will steepen.
What Does This Mean?
Steepening of the yield curve means the gap between shorter-term and longer-term debt is widening. This steepening has happened whenever the markets begin to push long-term rates higher during periods of economic recovery following a recession.
Figure 1 below shows the yield curve for the past 30 years. In these 30 years, we have seen three recessions. Figure 2 shows the credit spread & yield curve cycle between 2006-2017 (the period of the great financial crisis). It is noteworthy that this cycle is very similar to the one that happened between 1996-2005, the period of the dot com recession.
Figure 1: Yield Spread (source: longtermtrends.net)
Figure 2: Credit Spread & Yield Curve Cycle (Source: cmegroup.com)
Currently, we are in the recession-early recovery stage on the cycle in Figure 2. We expect the yield curve to become steeper and the credit spread to continue to widen as long-term rates increase.
In fact, PIMCO, the leading U.S. bond manager has warned on August 1st of inflationary pressure from housing rental costs that could push interest rates higher and overturn a sense of complacency among investors. Owners' equivalent rent is a key input used for calculating the U.S. consumer price index. As rents become more expensive, investors could become increasingly concerned about "sticky inflation", pushing the 10-year Treasury yield back towards 1.75%.
The biggest beneficiaries of the widening spread situation are banks. These institutions borrow short-term at low rates (mostly from interest-bearing liabilities - customer deposits) and then loan that money out for the long term at higher rates (interest-earning assets - loans). A widening spread means higher profit margins for banks.
The good news is that banks and financial institutions are still trading at attractive valuations today, and offer a great entry point.
John Hancock Financial Opportunity CEF: BTO - Yield 5.4%
To hedge our portfolio against inflation and higher long-term interest rates, we want an investment with dual benefits.
- The investment should benefit from a wider yield spread.
- The securities in consideration should also have a proven track record of solid performance with current income-yielding characteristics (just in case inflation comes in less than we think or takes longer to materialize).
With that said, we present to you a CEF (Closed-End Fund) - John Hancock Financial Opportunity Fund (BTO) with precisely these characteristics. BTO invests in financial services companies worldwide and the value of its portfolio has more than doubled in 10 years, and the CEF's distributions have continuously increased. This is noteworthy because the interest rate spread has been relatively narrow during this time, as seen in Figures 1 and 2 above.
Solid and Dependable Track Record
The fund's NAV (Net Asset Value) has also recovered strongly from its pandemic lows, and BTO did not reduce its distribution through the global pandemic.
As income investors, we seek protection from this red-hot inflation, and rising distributions will help to a good extent. Even in a non-optimal period for financial institutions, BTO has continued to increase its distributions. Growing distributions along with growing NAV indicates that BTO earns the distributions it pays out to investors.
And at no point did BTO have to use ROC (return of capital) to cover its distribution. BTO's distribution mainly comes from the fund's income from its equity holdings and long-term capital gains. These are highly dependable sources. And, it gets better. Between 25% and 30% of the distribution is classified as tax-advantaged QDI. That makes its 5.4% yield even more attractive. Investors should fully expect BTO to hike its distributions significantly as the interest spread widens, thus not only protecting investors from higher inflation, and also boosting their income in the process.
Over the past ten years, BTO has had a total return CAGR of 15%, including dividends reinvested (source: CEFData), and the fund has outperformed the S&P500 during this period.
Source: CEFData (full list of holdings)
98% of the fund's holdings are in the financial services sector, and the top 10 holdings are banking institutions. JPMorgan (JPM), Citigroup (C), and Bank of America (BAC) are among the largest banks in BTO's portfolio, while many other holdings are relatively smaller financial institutions.
Looking at BTO's sector breakdown, it is noteworthy that all investment sub-sectors should do well with a wider credit spread (higher inflation) except perhaps the IT services sector.
Source: BTO Semi-Annual Report
BTO uses a relatively modest amount of leverage around 15%. Total fees are 2.08%, of which 1.32% is paid to management (with the balance of 0.76% paying for the leverage).
BTO currently trades at a 12.1% premium to its NAV (Data Source: jhinvestments.com). With its NAV continuing to increase and favorable conditions for its constituent sector in the future, this valuation presents an opportunity to protect your portfolio in an inflationary environment more effectively.
Continued economic growth is critical for the banking sector to perform well. Hence, the most consideration-worthy risk with BTO is inflation taking off, leaving the economy in a stagnating state. The likelihood of this risk is low since FOMC members' projections for GDP growth moderating to 3-3.5% next year from about 7% this year. If these forecasts are used as guidance, banks (and, as a result, BTO) will do exceptionally well, and BTO is set to continue to be a rewarding opportunity for income investors.
The Federal Reserve has recently admitted what we have been warning for several months now: "Inflation will be higher and more persistent than expected". Their inaction now to curb inflation means more drastic measures must be taken later. Your portfolio can face a tidal wave of inflation impacts now, and the second tsunami of impacts when interest rates are raised.
The banking sector is poised to outperform in an inflationary environment with wider credit spreads. Most banks benefit from the spread between rates they charge for loans, and the interest they pay to depositors. The interest rates on saving accounts always lag the rates provided on loans. BTO, with its diversified exposure to banks, provides an excellent hedge against inflation for exactly this reason. This CEF has a history of outperforming the S&P 500, growing its NAV and distributions. Even more great news, the Banking and Financial sector today is undervalued and offers a great entry point.
The future is very bright for BTO. It is set to shine even more as banks and financials experience tailwinds from both higher inflation and a widening interest rate spread, as long-term interest rates rise in the next few years. This 5.4% yielder presents an exceptional opportunity to protect both the value of your investment and your income if you are a dividend investor like me from the wrath of the upcoming inflation. Now is the time to act: Boost your income now, and produce even higher income in the near future!
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