Investing for Income
[NC] Peter Boockvar, CIO of Bleakley Advisory Group and editor of the excellent Boock Report, states that a Fed-driven credit cycle now supersedes the traditional business cycle. Since debt drives so much GDP growth, its cost (i.e. interest rates) is the main variable defining where we are in the cycle. The Fed controls that cost—or at least tries to—so we all obsess on Fed policy. And rightly so. . .
[NC] At its July 31, 2019 monetary policy meeting, the Federal Reserve cut the Federal Funds Rate by a quarter percentage point as expected in order to cushion the economy from a global slowdown and escalating trade policy tensions. The stock market collapsed when Chairman Powell stated that this rate cut was a mid-course correction rather than the start of more rate cuts. It then recovered. The Fed also announced it would end the runoff of its $3.8 trillion asset portfolio two months earlier than previously planned. The probability of a rate change at the next Fed FOMC meeting is very high, and can be found here. http://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html
[NC] The 10-year to 3-month Treasury yield inversion is the most reliable signal of future recession, according to researchers at the San Francisco Fed. Inversions of that spread have preceded each of the past seven recessions, including the 2007-2009 contraction, according to the Cleveland Fed. They say it’s offered only two false positives — an inversion in late 1966 and a “very flat” curve in late 1998.
chart below shows the yield trend in the various treasury issues. The
10-year Treasury bond closed at a historic low of 1.37% in July
2016 (green arrow). The yield spread shown is the difference between the 10-year and
3-month treasury rates. A long-term
bear market in bonds appears to have started at the bottom of the
rate curve in July 2016. The 10-year rate dropped below the 3-month rate -- that is an inversion. This difference is shown in the spread curve below.
[NC] The 10-year minus 3-month yield spread is shown below since 1996, where a negative spread indicates an inverted yield curve. The flattening yield curve is often a warning of a slowing economy and a potential stock market peak. An inverted yield curve generally forecasts a future recession. It has preceded all of the past seven recessions since 1970, typically by four or five quarters.
[NC] A dynamic yield curve can be found at http://stockcharts.com/freecharts/yieldcurve.php.
[NC] The rates in Europe and Japan are negative for many bonds. Yields and history of global government bonds can be seen by clicking here.
[NC] Allocations for a portfolio can be divided into bonds (or other income funds), dividend-paying stocks and cash. Cash can be kept in a brokerage money market fund. An interest paying savings account is another approach and selections can be found here. The purchasing power of cash will deteriorate about 2% a year due to inflation. Short-term bond funds and bank-loan funds would be other lower-risk considerations. Ultra-safe 3-month Treasury bills are yielding over 2.4% (see above chart) and these could be rolled over every three months to get the next higher interest rate. The percent kept in each of these depends on your risk tolerance. Rebalancing to maintain your percentages can be done periodically. May and October are suggested as this would synchronize with the Power Zone.
[NC] Most equity index funds are capitalization weighted -- meaning the largest corporations get a greater percentage of the money invested in the fund. Bond index funds are different. They are structured according to the amount borrowed by the corporation. The largest borrowers get a higher percentage of the fund's invested money. The corporations' capacity to service their debt is not considered. Active bond managers aren't bound by the requirements of an index. Rob Arnott of Research Affiliates says the way to win in bond investing is to avoid defaults, which is where an active manager's judgment and credit analysis comes in. However, funds that contain a large number of bonds cushion any one bond default. In a strong economy, defaults should not be a problem.
Dividend-Paying Stock Funds
[NC] As discussed under the Observations tab, bonds do not give much income in this time of low interest rates. Investors have been supplementing their bond income with dividend-paying stocks. It was noted recently that rising interest rates puts downward pressure on high-dividend paying stocks as interest on bonds becomes more competitive for income investors. Stocks also raise the portfolio risk, but can be managed with attention and periodic rebalancing. Funds, rather than stocks, provide diversification, as a bad earnings report from a company can affect its stock price significantly.
[NC] The chart below shows the latest eight months. The rise from 12/24/18 has been dramatic. Investment in corporate bonds (light blue) has paid off with much less volatility. This chart shows four dividend ETFs together with a light blue investment-grade corporate bond fund (LQD) and the black S&P 500 SPDRs (SPY) for comparison. Click here for the latest or to add your ETF or stock to the chart. A similar chart for bond funds is below.
[NC] The distribution yield (as of 1/10/2019) and expense ratio are given in the table.
[NC] Bond funds provide a balance to an equity
portfolio. Use a bond fund or consider
a bond or fund ladder (July 2012 article on pros &
cons). Individual bonds would need to be held to maturity
in this rising interest rate envioronment. Ultra-safe 3-month Treasury
bills are yielding over 2.35% and these could be rolled over every three
months to get the next higher interest rate.
[NC] Bond fund holdings are weighted giving the highest weight to the borrowers that have the largest debt. That would seem to encourage companies to take on more debt, which would not be good when economic activity starts to drop. Also consider floating-rate funds and senior bank loan funds that are described below. These are short-term and thus have little sensitivity to interest rate changes.
[NC] There are three types of risk in the bond
Interest rate risk, bond default risk, and liquidity risk. Interest
rate risk occurs if rates rise causing the price of bonds to decline.
As interest rates fall, bond prices rise, which would result in a
capital gain that would be added to the income stream. The default
risk depends on the quality of the bond as rated: AAA down to
below junk status CCC. Liquidity risk is a measure of the
ability of the bond dealer to buy bonds or sell bonds from his
inventory to service the market. Inventories have been dropping
dramatically in the last few years, as shown below.
[NC] This eight-month chart shows
the recent movement
of the total return (interest reinvested) of various
typical bond-type funds.Corporate bonds (red) have done the best
as there is more risk to these types of bonds. See below for the
sensitivity of bonds to interest rate changes. Click here for the latest. Note measures of risk in the
The yields to maturity and descriptions
below are as of 1/10/2019. The chart above shows the
volatility and impact of changing rates -- demonstrated by the blue 7-10
year Treasury bond fund. Duration is a measure of
the sensitivity of bonds to interest rate changes. A bond with a
5-year duration will move down 5% if the market interest rate for the
bond increases 1%. Therefore, short-term bonds are safer than these shown
here except for FLOT, SRLN and HYGH.
[NC] The iShares Core US
Aggregate Bond ETF (AGG) with 34.4 billion in
assets is the fund has become the standard for measuring bond fund
returns. It yields 2.66% with a duration of 6.7 years. It's
expense ratio is only 0.08%.
[NC] PIMCO Enhanced Short-Maturity
ETF (MINT) is yielding 1.59% with 0.35% annual
expenses. It has an average duration of 0.32 years, and is
actively managed by Jerome Schneider. It's price has been dropping
since the end of October 2017.
[NC] Senior bank loans are loans to borrowers that have below investment grade credit ratings. In the event of a default, these bank loans are repaid before other creditors. They are short-term loans and the ETF tends to increase in price when interest rates rise. SPDR Blackstone GSO Senior Loan ETF SRLN yields 4.0% with a 0.70% expense ratio. This ETF provides actively managed exposure to noninvestment-grade, floating-rate senior secured debt of US and non-US corporations that resets in 3 months or less. Current reset is 22 days. Read more here.
[NC] High-yield bonds move more like stocks. The iShares iBoxx High-Yield Corporate Bond fund HYG is a 3-star fund with a yield to maturity of 5.64% and an expense ratio of 0.49%. It's duration is 3.65 years with 74% of holding in the U.S. There is an interest rate hedged fund HYGH, the iShares High Yield Interest Rate Hedged fund. This fund yields 6.01% (5.01% on 6/15/18) with an expense ratio of 0.54%. It's duration is stated to be zero.
[NC] If interest rates go up, bond prices will go down, unless sold at or near maturity. Rates are quite low now -- and the Fed is expected to slowly raise the (short-term) Federal Funds Rate as it has been doing. However, the long-term rates are market driven. An analysis of this chart can be found here. A chart of long-term interest rates back to when the U.S. Constitution was ratified in 1788 is provided by Barron's.
Chart source is given at the top right of the chart. This page is for amusement only, and should not be taken as advice to buy or sell anything.