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] Interest rate futures indicate what the Fed might do with the rate in the future as given by the CME Group’s FedWatch Tool.
Fed officials indicate that they will be raising interest rates three
or four times this year, after they complete the tapering off their
buying program March. Federal Reserve Chair Jerome Powell said on
that “the risk of higher inflation has increased.”
[NC] The coronavirus impact on the economy caused a recession. 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, and it worked again this time.
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.
[NC] The 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. Since then that low has been superseded by the lowest rate in history of 0.54% occurring on 3/9/2020. The yield spread shown is the difference between the 10-year and 3-month treasury rates. When the 10-year rate drops below the 3-month rate, that is a yield curve inversion.
[NC] The 10-year minus 2-year yield spread is shown below since 1998, where a negative spread indicates an inverted yield curve. A 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. This yield curve inverted in the first week of April.
[NC] A dynamic yield curve can be found at http://stockcharts.com/freecharts/yieldcurve.php.
[NC] Yields and history of global government bonds can be seen by clicking here.
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 due to inflation. Treasury Series I (Inflation) Bonds provide a good return of 9.62% through October and must be held one year. The rate is based on inflation and changes every six months. Short-term bond funds and bank-loan funds would be other lower-risk considerations. Ultra-safe 3-month Treasury bills are yielding around 0.8% (see above chart) so it's not worth the trouble to keep rolling them over as in the past. 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 and high-yield bonds should be considered.
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 last six months. 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 10/8/2021) and expense ratio (ER) are given in the table.
Bonds provide a balance to an equity
bonds would need to be held to maturity in this rising
interest rate envioronment. Long or intermediate-term bonds should not
be bought as a capital loss is likely as their prices drop as interest
rates rise. Due
to inflation, Treasury Inflation Protection Securities (TIPS) should be
considered, although they are not doing too well recently. Click here to learn the subtities of TIPS. Also check out the one-year Treasury I-Bonds that are currently yielding 9.62% through October 2022.
[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. The price of bond
ETFs sometimes lags behind or gets ahead of its NAV (net asset value),
which is based on an index. This dislocation is described in this article.
[NC] This six-month chart shows
the recent movement of
the total return (interest reinvested) of various
typical bond-type funds. Treasuries (blue) have received the most money as they are
the ultimate "safe haven." TIPS (light green) have also been going down since early March. See below for the
sensitivity of bonds to interest rate changes. Click here for the latest. Note measures of risk in the
[NC] The yields to maturity and descriptions
below are as of 10/8/2021. 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 75 billion in
assets is the fund has become the standard for measuring bond fund
expense ratio is only 0.04%.
[NC] PIMCO Enhanced Short-Maturity
ETF (MINT) is yielding 2.27% with 0.36% annual
expenses. It has an average duration of 0.32 years, and is
[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 has 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. 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 an expense ratio of 0.49%. It's duration is 9.4 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 has a duration of zero with an expense ratio of 0.53%.
[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 keep 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.