Musings on the Income Markets
By: Tim McPartland,
Last week was a wild and crazy week for most equity markets around the world and we are expecting more of the same for the next week or two as the FED ponders raising the Fed Funds rate (the interest rate that financial institutions charge one another on overnight lending). If the Fed raises rates the markets will begin guessing when the next hike will be, while if the Fed doesn’t raise the rate they may be signaling a weak U.S. economy. This will be the main market driver for the forseeable future.
It has been interesting to watch interest rates over the last couple of weeks. We watch the 10 year treasury as an indicator of longer term interest rates and it has mostly traded in a range of 2.15% to 2.27% which we consider a very tight range. The 10 year rate did spike up to 2.35% on December 3rd as Fed officials were spouting off in a bullish fashion which spooked the markets for all of 24 hours, before falling back to 2.20% within a few days. Irrespective of the economic news the 10 year treasury rate has remained fairly constant. Let’s face it – no one believes that there is any real lasting strength in the U.S. economy and we all know that the global situation is far from stellar. It remains our belief that a Fed Funds rate hike on Wednesday may be met with a kneejerk move higher in the 10 year interest rate, before drifting lower in a fashion that serves to further flatten the yield curve in a indicator that traders believe we may enter a recession next year.
Last week, as might have been expected, anything related to energy was hammered lowered. It didn’t matter whether it was a downstream, midstream, or upstream company with crude at $35/barrel and natural gas at $2.00/MMbtu there simply is no confidence that energy will ever be profitable again (although it will be and this kind of capitulation is a necessary part of the bottoming process). Remember that markets almost always exaggerate their movements–too optimistic when heading higher, while too pessimistic when heading lower.
Yesterday (Monday) preferred stocks of every size and shape took their heaviest losses of the year. On average, preferred shares were down by 2%, while shares of preferred stock closed end funds (CEFs) fell by 3%. Exchange Traded Debt issues ($25 Baby Bonds) incurred the same level of losses. Shares of mREIT preferreds (mortgage real estate investment trusts) took losses that were the largest of the sector–in many cases 3-5%. To understand the breadth of falling prices we note that we began the day with about 145 $25 preferred issues trading below par, while at the end of the day there were 204 issues under par. While we can only speculate on the cause of the bloodbath today in preferred stocks it seems likely that the Fed rate increase that will almost certainly occur on Wednesday was not built into prices. It seems silly that anyone would have thought that the Fed would hold steady with the ongoing signals that the Fed officials have been giving the marketplace (although it is possible they will not move rates-but we are not counting on it). With trading today we will have a much better idea of what income investors are thinking when preferred shares and baby bonds either stabilize or continue to drop in price.
When this year began we wrote about how difficult we thought the year would be for income investors and certainly we have not been disappointed–the struggle to stay even for the year continues. After the rout in shares today we are just above breakeven with a gain of .08% in the 2015 Blended Income Portfolio. To put a positive spin on the lack of return for 2015 forces us to look back to 2014 and our gain of 9.76% in the 2014 Blended Income Portfolio. The 2014/2015 Short/Moderate Duration Portfolio which ended the 1st year of existence in October with a gain of 6.2% has now given back 1.5% of that gain–ouch. In many ways we are excited to enter a interest rate hiking cycle since our site has been about education since the day it was lauched in 2006 and we have had no 1st hand chance to watch the reaction of income securities to higher interest rates. On the financial side we are somewhat scared, while on the educational side we are excited. Let’s hope that cooler head prevail, although that is probably asking too much of the Wall Street types.
It is our intention to mostly sit tight with our portfolios this week, although today we took the opportunity to buy a small position in Public Storage (ticker:PSA) preferreds in our personal portfolio as they went on “sale”. Investors had driven investment grade preferreds and baby bonds too high–too high above par, in recent months and the sell off today allowed us to enter PSA preferreds at under par ($25.00) value. We have more than adequate cash reserves available if some high quality issues fall hard and we can pick them up on the cheap, but we are only interested in the high quality issues as we enter a potential rate hiking cycle.
We hope that conservative income investors have positioned themselves properly for a rate hiking cycle. “Properly” means different things to different people. For us it meant weighting our portfolio toward shorter duration securities–baby bonds or term preferreds (securities with definite call dates). For others it may well have a different meaning altogether, in fact some investors may have made no preparations for a rate hike as they may be insensitive to their capital position and instead focus on their income stream. But regardless of how the markets move through the balance of the week we would encourage investors to be “cool” and not make rash, quick moves–this too shall pass.