LOW RATES, BIG OPPORTUNITIES / BARRON´S FEATURE ( A MUST READ )

 

Feature

SATURDAY, AUGUST 13, 2011

Low Rates, Big Opportunities

By RANDALL W. FORSYTH 

With the Fed holding short-term rates near zero, investors need to extend their search for income. Here's where to find it.

A lot can happen in three decades, as a perusal of Barron's issue of Aug. 17, 1981, reveals.


International Business Machines (IBM) made its long-awaited move into the personal-computer business and the Trader column noted Apple (AAPL), which still had "Computer" in its name, shed 10% of its equity valuation over the daunting prospect of competing against Big Blue. Last week, ironically, Apple for a time became the most valuable company on earth in terms of stock-market capitalization, briefly topping Exxon Mobil (XOM), which was two independent oil companies 30 years ago.

Angst over interest rates also dominated the investment scene in 1981. And so it does again, but for very different reasons.

Thirty years ago yields on Treasury notes were closing in on never-before-seen levels in the mid-teens, while money-market funds were paying 17%. Those astronomical rates were the Federal Reserve's way of fighting double-digit inflation.
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Such a scenario is all but impossible to imagine now, especially after the Federal Open Market Committee declared its plan last week to keep short-term rates at the rock-bottom levels that have prevailed since the central bank put them there in December 2008, as part of its effort to counter the worst financial crisis since the Great Depression. In effect the Fed, led by Chairman Ben Bernanke, declared it would do whatever it takes to generate a sustainable economic recovery in order to lower unemployment from 9%-plus, just as the Paul Volcker-led Fed of three decades ago vowed to slay the inflation dragon, no matter what. As a result, after another lost decade for stocks marked by two wicked bear markets, investors now face record low yields on super-safe Treasury securities and bank deposits.


The Fed's declaration that it plans to keep its target for the overnight federal-funds rate at 0-0.25% for nearly another two years has had a dual effect. Investors in the Treasury market had priced in an eventual increase in short-term interest rates, but the message from Bernanke & Co. is that, given the state of the economy and receding inflation pressures, a rate hike isn't in prospect this year or next.

That puts the Treasury yield curve in a different perspective, says Robert Kessler, president of the Denver money-management firm Kessler Companies, which manages institutional portfolios of Treasury securities. Historically, he says, the 10-year Treasury note has yielded 125 basis points (1.25 percentage points) over the fed-funds rate, which means the 10-year note should yield about 1.25%, or approximately 100 basis points less than the 2.20% level touched Wednesday in the post-FOMC bond rally. (The benchmark note yield bounced back to 2.34% Thursday.) A 10-year U.S. note yield in the low 1% range isn't without precedent elsewhere; both Switzerland and Japan have comparable yields on their 10-year bonds.

Even at today's yields, 30-year zero-coupon Treasury STRIPS would provide equity-like total returns if yields return to 2008-09 lows, Kessler says. A 100 basis-point decline from Thursday's 4.25% would generate a 30% total return. The 30-year bond yield fell below 2.50% in early 2009, so 3.25% wouldn't be unprecedented.
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P.C. Vey for Barron's

Muni bonds, closed-end funds, mortgage REITs, high-yield corporates and, yes, equities, are just some of the alternatives to Treasuries with paltry yields.

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In the Treasury market's vicious correction Thursday of the recent rally, however, the Pimco 25+ Year Zero-Coupon U.S. Treasury Index ETF (ticker: ZROZ), an exchange-traded fund that tracks long STRIPS, fell 9.1%, equal to a thousand-point drop in the Dow. That was the result of the most violent swing in the Treasury market seen in years—an increase of 27 basis points in the 30-year bond yield after an auction of that maturity drew poor demand at the depressed yields that resulted from the market's rally. Friday the long bond recouped almost half of the previous session's loss.

WHILE KESSLER HAS BEEN A STAUNCH and lonely—but prescient—bull on the Treasury market, many other fixed-income professionals think other sectors of the bond market hold greater attraction. They also say equities now offer better returns—and income—than bonds. (For more, see the profile of BlackRock's Larry Fink.)

Even staying within the confines of the bond market, the plunge in Treasury yields and the Fed's "astonishing promise" to keep rates on cash equivalents near zero for nearly two years argue strongly for investors to leave those safe havens, says market veteran James Kochan, chief fixed-income strategist at Wells Fargo Funds Management.

In particular, the municipal market has become "extremely cheap"—high in yield, in bondspeak—relative to Treasuries, not because of hysterical and unfounded predictions of a surge of defaults, but because muni yields haven't dropped as much as Treasuries. As a result, yields on double-A rated munis rose last week to a 30% premium over comparable Treasuries, which were yielding about 2.24%.

A Long Way Down

Thirty years ago, the Volcker Fed fought inflation with double-digit Treasury yields. Today the Bernanke Fed is fighting economic stagnation with rock-bottom rates. For savers, it has been a slippery slope.

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The Fed's decision to pin short-term rates to the floor, while impoverishing savers, basically takes away the risk for investors who want to use leverage to boost returns. For those looking for the highest tax-free income, levered closed-end muni funds are the deal.
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Closed-end funds, unlike open-end mutual funds, issue only a set number of shares, which trade like other stocks on exchanges. Closed-ends can sell above or below their underlying net-asset value, which offers opportunities when they fall to discounts.
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That happened in last Monday's stock-market slaughter following S&P's downgrade of the U.S. credit rating, says Sangeeta Marfatia, senior closed-end fund analyst at UBS Wealth Management. Her picks among the national funds on the bargain counter are the Nuveeen Premium Income Municipal 2 Fund (NPM) and the BlackRock MuniYield Quality Fund (MQY), which were trading at discounts of more than 7% last week and yielding in the high-6% range—equivalent to a fully taxable return over 10%.

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BCA RESEARCH RECOMMENDS moving into mortgage-backed securities after spreads over Treasuries jumped to "post-crisis highs." They offer "an attractive alternative to Treasury securities with limited risk." Funds are the only way to go for individuals, and the Vanguard GNMA (VFIIX) gets a five-star rating from Morningstar for its steady returns and low costs. The Sit US Government Securities Fund (SNGVX) also gets five stars for generating steady returns by concentrating on high-coupon seasoned mortgage securities that generate high yields with low volatilities.
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Finally, the relatively new DoubleLine Total Return Bond Fund (DLTNX), managed by Jeffrey Gundlach (whom Barron's dubbed the "The King of Bonds" in a Feb. 21 cover story) has ventured away from plain-vanilla mortgage-backed securities and has been in the first percentile in its category for the latest 12 months, with a 13.15% total return versus 5.11% for the Barclays Aggregate Index, according to Morningstar.
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BCA points out that the Fed's policy means the cost of funding "carry trades"—borrowing at low short-term rates to invest in higher-yielding assets—is "now guaranteed for a fixed period, which should attract banks and other investors into the market." Real-estate investment trusts that utilize the strategy for investing in MBS can exploit the wide spread between zero borrowing costs and 3%-4% on mortgage-securities to produce yields in the mid-teens. Mortgage REITs were hit in the market plunge following S&P's lowering of U.S. debt, which extended to mortgage giants Fannie Mae and Freddie Mac, now in federal conservatorship. The iShares FTSE NAREIT Mortgage Plus Capped Index ETF (REM) provides one-stop diversified exposure to the sector, with Annaly Capital (NLY), the No. 1 mortgage REIT, accounting for about 26% of the fund, followed by American Capital Agency (AGNC) at 11%. 

The Bottom Line.

In addition to muni bonds, corporates and preferreds, a wide variety of mutual funds and closed-end funds offer attractive yields for income investors.

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Kochan also recommends moving into high-yield corporate bonds, which have seen their yield spreads widen substantially to above 500 basis points for the first time this year, from as narrow as 350 basis points. That view is seconded by Dan Fuss, the long-time fixed-income maven at Loomis Sayles, who says he was moving money into the Loomis Sayles Strategic Income Fund (NEFZX) and the Loomis Sayles Institutional High Income Fund (LSHIX) for a charitable fund he oversees. These funds have fewer restrictions on holding equities and junk bonds than the Loomis Sayles Bond Fund (LSBRX) that he co-manages.

Without being able to name specific names, Fuss likes very large, liquid stocks that enjoy a yield advantage over Treasuries right from the start. "They may not be down like the Russell [2000 small-cap index] but they're being sold because they're big and liquid" and thus able to find bids, he says. That hasn't been the case in the high-yield market, where Wall Street dealers have stepped back from providing liquidity. That has made for some opportunities for Loomis Sayles.

Another sector hit hard in last week's market maelstrom were preferred stocks, especially those issued by banks, as Andrew Bary reported on Barrons.com ("Yield to Bank Preferred Stocks," Aug. 8). Here, too, closed-end funds provide an interesting way to participate in this beaten down sector. Marfatia of UBS likes the John Hancock Preferred Income II (HPF) and John Hancock Preferred III (HPS), in part because these funds are diversified and not solely in financial names.

BUT PERHAPS THE BIGGEST beneficiaries of zero interest rates will be capital-intensive blue-chip corporations, which can refinance their debt as homeowners did in the past decade, writes David P. Goldman, former head of credit research at Bank of America, in a special study. That will lower their cost of capital, which will help sustain earnings. For instance, A2-rated Con Edison (ED) now can borrow at 4%, below its average interest cost just under 6%. "Over time, its interest cost should fall by nearly $200 million, increasing its bottom line by 20%," he says.

Low interest rates also add to the allure of closed-end equity funds by the ability to use cheap leverage. Marfatia's top pick is the John Hancock Tax-Advantaged Dividend Income Fund (HTD), which trades at about a 6% discount and generates a 7.69% yield on its recently increased dividend. But she isn't a fan of closed-end funds that use options-writing to generate income since many of their distributions represent a return of capital if the funds don't generate capital gains.

While it can be rewarding to research the often murky, inefficient market for closed-end funds, a quick-and-easy route is to buy funds of closed-end funds. The RiverNorth Core Opportunity open-end fund (RNCOX) has earned five stars from Morningstar, while Cohen & Steers Closed-End Opportunity Fund (FOF) has four stars.

While savers will continue to bemoan the lack of yield, there are many ways to make the Fed's near-zero interest-rate work in your favor.
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Winning Plays for a Low-Yield World

Here are some investments that could help investors prosper while rates remain puny.

Investment	Way to Play	Comments
Long Treasury zero-coupon	Treasury STRIPS; Vanguard Ex Dur (EDV), Pimco 25+ Zero (ZROZ)	ETFs easier to trade for individuals than Treasuries.
Mortgage-Backed Securities	Vanguard GNMA (VFIIX), Sit US Govt Secs (SNGVX), DoubleLine Total Return (DLTNX)	Vanguard is a long-term steady fund. Sit has very low volatility. Gundlach is a mortgage master.
Municipal Bonds	10-yr AA or A GOs; Nuveen Prem Inc Muni 2 (NPM), BlackRock MuniYld Qual (MQY)	Munis cheap, says Wells' Kochan. Closed-end funds benefit from low short rates.
Mortgage REITs	iShares FTSE NAREIT Mort Plus ETF (REM)	Pure yield-curve play; ETF provides diversification among REITs.
Preferred Stocks	J. Hancock Pfd Inc. II (HPF), J. Hancock Pfd Inc. III (HPS)	Closed-end funds provide extra yield through leverage; not just financials, says UBS' Marfatia.
Junk Bonds	Fidelity Hi Inc (SPHIX), T Rowe Hi-Yld (PRHYX), Vanguard Hi-Yld Corp (VWEHX)	Morningstar picks of no-load high-yield funds.
Low-Yield Beneficiary Stocks	Capital-intensive blue chips, utilties such as Con Ed (ED)	US corporates' refis to add significantly to bottom line, says David Goldman.
Closed-End Equity Funds	J. Hancock Tax-Ad Div. Income (HTD)	Leverage generates 7.69% yield from big-cap stocks. Recently hiked dividend, says UBS' Marfatia.
Funds of CEFs	Cohen & Steers Closed-End Opp (FOF), RiverNorth Core Oppty (RNCOX)	Diversified, managed portfolios to take advantage of closed-end opportunities.

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