Higher Rates Don’t Faze Income Issues-Yet
By: Tim McPartland,
On June 27 we wrote, “It has been a pretty incredible two years for income investors. We have had four Fed Funds rate hikes from a low of 0-1/4% to the current rate of 1-1 1/4%. Two years ago the 10 year treasury was at 2.2% before falling to 1.5% a year ago, then rising to 2.6% and subsequently drifting back down to 2.1% a few days ago.”
Of course, little did we know that only days later various central bank officials around the globe would all begin to talk about the coming end to quantitative easing (QE). Since we wrote the above 13 days ago the 10 year treasury has jumped to close at 2.37% on July 10 because of Fed QE taper talk. The European Central Bank (ECB) signaled that they may begin to cut back on their 60 billion Euro monthly purchases of assets which caused the German 10-year to rise to 0.57%, its highest rate since 18 months ago.
This occurred in spite of weak inflation data across the euro zone, which ECB President Mario Draghi, acknowledged. Simultaneous with the ECB signals, there is talk by some analysts that while the Bank of Japan has remained dovish on its QE program they likely will have to begin discussing a “taper” by the end of the year. And through all of this, the average preferred stock and baby bond moved lower by a measly 1 cent!
We have written for the last year about how the Fed can drive up short-term interest rates, but it would be the marketplace that would determine the yield of the 10-year and 30-year treasuries. This continues to be true, but now we may be on the verge of one of the biggest buyers — the Federal Reserve — reducing demand in the debt marketplace in a way that will be meaningful to income investors. Only then, or shortly before the actual “taper” begins, will holders of preferred stocks and baby bonds (exchange-traded debt with face values of under $1,000) potentially begin to understand the difference between holding securities with no maturity date (perpetual preferreds) and those that have maturity dates of 20, 30 or even 100 years in the future.
It is our firm belief (right or wrong) that the next 90 days hold the potential for a harmful “event” as global markets adjust to the coming QE taper. A harmful event could mean a short-term panic of sorts with potential to take preferred stocks and baby bond prices down by 20% until investors adjust. Investors should use some restraint when considering purchases and holdings of perpetual preferreds in the months ahead as we transition to a tapering of Fed holdings. It has been our experience that shortening maturities in your portfolio will reduce returns by about 1% and this is a cheap price to pay for peace of mind.
Since we are writing about QE tapers and rising interest rates, we should mention that in October our Short/Medium Term Income Portfolio will be three years old. We constructed this portfolio to help avert the decimation, which was believed to be coming to preferred stocks and “baby bonds” because of higher interest rates. The holdings in this model are all shorter duration term preferreds and baby bonds, which are much less susceptible to wide swings in value than perpetual preferred stocks since the time to maturity is only a few years away. In hindsight, we were three years early with the need for this portfolio, but we had plenty of company as it was pretty much a consensus that rates would be moving higher “soon”. Just the same, the model has performed well and assuming no “black swans” sweep down on the market in the next four months, we should realize a low risk, low stress 7% annualized return. We will continue to operate this model in the months ahead so we can observe how the holdings perform compared to perpetual preferred stocks.
Lastly, in order to add a little punch to our very conservative Short/Medium Term Income Portfolio mentioned above, we constructed a Short/Medium Term Income Portfolio with Zip in August, 2015. We attempt to purchase primarily short duration term preferreds and baby bonds in this model but we devote 5-15% to the ownership of undervalued real estate investment trusts (REITs) and master limited partnerships (MLPs). As we look to close out the second year of this model, it looks like we should have returns in the area of 8% annually.
We have shown that a conservative income investor can realize pretty decent returns without spending all day long searching for the best income issues and continually trading your account. Investors should review the above models and come up with their own ideas on how to deal with possibility of how to deal with the possibility of rising interest rates.
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Tim McPartland is a private investor with over 45 years of investment experience. His analysis, research and writing is devoted to the hunt for income producing securities of all types, but in particular specializing in preferred stocks, exchange traded debt and Master Limited Partnerships.