The Role Of Fixed Income

1/14/2013


In an environment where cash holdings pay virtually nothing and the 10-year Treasury note yields just 1.9% — well below its 10-year average of 3.7% — income-oriented investors thirst for higher yields.

We compare some alternatives in the chart below and the table at the top of page 4. Income-focused equities — even the broad S&P 500 Index — currently boast higher yields than the 10-year Treasury. Still, we devote most of the following paragraphs to fixed-income investments.

Corporate bonds and preferred stocks — particularly those with credit ratings several steps below AAA — delivered excellent returns last year. A Bank of America/Merrill Lynch index of BBB-rated corporate bonds returned 12% in 2012, while the iShares S&P U.S. Preferred Stock Index returned 18%. Indexes of bonds rated AAA, BBB, and below investment grade all outperformed the S&P 500 Index over the last five and 10 years.

Given today's historically low interest rates, investors shouldn't expect bonds to duplicate their robust returns over the next year or two. Yields for the BBB and high-yield indexes below have dipped to at least 15-year lows in the wake of strong price gains, and the AAA index's 2.1% yield is lower than 93% of its monthly yields since 1997.

Many analysts say the bull-market in bonds has ended. Yields on Treasurys and the highest-rated corporate bonds are in some cases so low that owners of these securities lose money on an inflation-adjusted basis. And when interest rates rise, bonds and bond funds generally lose value. For example, in 2008, the index of BBB-rated bonds began the year yielding 6.1% and ended at 9.7%. During that year, the index delivered a negative return of nearly 12% — including dividends.

Still, it may make sense to keep some money in fixed income, especially if you are willing to look beyond Treasurys and the highest-quality corporate bonds. Fixed-income securities still have a role to play, especially when you consider history.

Diversification benefits

Bonds are not highly correlated with stocks; this means they don't usually move up and down with equities. For example, based on Morningstar data from 1972 through 2011, large-company stocks had a 0.29 correlation with long-term corporate bonds and a 0.06 correlation with long-term government bonds. A 1.0 correlation implies that asset classes move in lockstep, while a -1.0 correlation reflects perfect opposite movement.

BONDS IMPROVE RATIO OF RETURN/RISK
According to Morningstar, from 1926 through 2011 large-company stocks generated an annualized return of 9.8%. However, adding a 10% weighting in long-term government bonds reduced the annualized return only slightly, to 9.6%, while reducing the standard deviation (a measure of risk) quite a bit more. The information ratio measures return per unit of risk.
Portfolio
Compound
Annual
Return
(%)
Value of $1
Invested
In 1926
($)
Average
Annual
Return
(%)
Standard
Deviation
(%)
Information
Ratio
100% Stocks
9.8
3,102
11.8
20.3
0.58
90% Stocks/10% Bonds
9.6
2,652
11.2
18.3
0.61
70% Stocks/30% Bonds
9.0
1,654
10.0
14.5
0.69
50% Stocks/50% Bonds
8.3
950
8.9
11.3
0.79

The table just above illustrates the effect of this diversification. Based on Morningstar data from 1926 through 2011, adding bonds to an all-stock portfolio would have reduced volatility more than it reduced returns. In other words, adding up to a 50% weighting in bonds boosted return per unit of risk.

Yield-spread analysis

The S&P 500 Index yields 2.1%, above the 10-year Treasury note's 1.9%, an unusual phenomenon. Over the last decade, the index has averaged a yield 1.8% below that of the 10-year Treasury. While the yields of REITs and MLPs have dipped below historical norms, the spreads between their yields and the Treasury yield are well above 10-year averages. In contrast, spreads between corporate and Treasury bonds have narrowed.

YIELD AND SPREAD COMPARISON
Yields on most types of bonds and preferred stocks are well below historical norms — not surprising given the Fed's efforts to keep interest rates low. AAA is the highest bond rating, BBB is the lowest investment-grade rating, and "high-yield" reflects bonds below investment grade. Spreads between stocks and the 10-year Treasury are well above historical norms, while the yield premium of most bond and preferred-stock indexes has shrunk.
10-Yr.
Treasury
Yield
(%)
S&P 500
---- Index ----
Real Estate
---- Index ----
U.S. MLP
---- Index ----
U.S. Corporate
-- AAA Index --
U.S. Corporate
-- BBB Index --
U.S. High-Yield
---- Index ----
Preferred
-- Stock Index --
Yield
(%)
Spread
(%)
Yield
(%)
Spread
(%)
Yield
(%)
Spread
(%)
Yield
(%)
Spread
(%)
Yield
(%)
Spread
(%)
Yield
(%)
Spread
(%)
Yield
(%)
Spread
(%)
Current
1.9
2.1
0.3
4.4
2.5
6.3
4.4
2.1
0.2
3.3
1.5
6.1
4.2
6.5
4.6
5-Year
Average
2.9
2.2
(0.7)
5.3
2.4
7.3
4.4
3.3
0.4
5.6
2.7
10.0
7.1
7.8
4.9
10-Year
Average
3.7
2.0
(1.8)
5.4
1.7
7.1
3.3
4.1
0.4
5.7
2.0
9.4
5.7
NA
NA
15-Year
Average
4.3
1.8
(2.5)
6.0
1.7
7.6
3.2
4.8
0.5
6.2
1.9
9.9
5.6
NA
NA
Sources: NAREIT, Alerian, Federal Reserve.    Note: The bond indexes are from Bank of America/Merrill Lynch, the preferred index from S&P.

 

Below, we briefly address a number of asset classes:

Government bonds. Yields on Treasury bonds (and most other bonds) have trended mostly lower over the last five years, driven by investors' flight to quality and the Federal Reserve's efforts to keep interest rates low. The 10-year Treasury issued in February 2007 at 4.625% trades at a 16% premium to par value, the amount the government will pay to retire the bonds in 2017. Such premiums make it tough for Treasurys to generate strong returns going forward. Treasurys have fallen so far this year, with the yield up to 1.9% from 1.8% at the end of December. Investment ideas: Vanguard GNMA ($11; VFIIX) holds securitized mortgage loans issued by government agencies. Vanguard Total Bond Market Index ($11; VBMFX) holds about 37% in Treasurys, 35% in other government-related bonds, and 21% in corporate bonds.

Investment-grade corporate bonds. Spreads between the highest-rated bonds and the 10-year Treasury have narrowed to 0.2%, versus the five-year average of 0.4%. Spreads for BBB-rated bonds have also narrowed. Investment idea: Vanguard Short-Term Investment-Grade ($10.83; VFSTX) is a low-volatility fund focusing on high-grade corporate bonds, as well as asset-backed and government securities. Short-term bonds are less sensitive to interest-rate changes.

High-yield bonds. Riskier than investment-grade bonds, junk bonds offer commensurately higher yields, with returns more closely correlated with stocks than are other types of bonds. However, junk-bond prices have soared as yields have reached record lows. Investment idea: Fidelity High Income ($9; SPHIX).

Preferred stocks. These securities trade like stocks but behave more like corporate bonds, in that they tend to rise and fall based on interest rates and issuer credit quality. Most preferreds are perpetual, unlike bonds, but do allow the issuer to call (repurchase) them for a preset price. Investment idea: We don't recommend any preferreds or cover them on an ongoing basis. However, the table below lists some investment-grade options. All trade at a premium to the call price, which could put pressure on the market price as call dates near.

REITs and MLPs. These securities trades like stocks, but they aren't traditional corporations; they don't pay taxes at the corporate level. MLPs must generate 90% of their cash flows from "qualifying sources," which for the most part limits them to natural resources, commodities, and real estate. REITs must pay out most of their earnings in dividends, and while MLPs are not required, most also offer big payouts to attract investors. Unlike bonds, the spread between the yields of REITs or MLPs and the 10-year Treasury is wider than usual. Investment idea: We don't recommend any REITs or MLPs for purchase, but interested investors can find a list below, with more at www.DowTheory.com/Go/Alt. In Portfolio Review, we cover a component of our Top 15 Utilities portfolio, MLP Plains All American Pipeline ($49; PAA).

ALTERNATIVE INCOME SOURCES
All of the royalty trusts, master limited partnerships, real estate investment trusts, and preferred stocks trade on stock exchanges, though they are not technically common stocks. At the moment, we don't recommend any of these securities on our buy lists, though their high yields may appeal to income-oriented investors.
Company (Price; Ticker)
Div.
($)
Yield
(%)
Overall
Quadrix
Score
Industry
Royalty Trusts
BP Prudhoe Bay ($78; BPT)
7.29
9.4
79
Oil/Gas Explor.
Cross Timbers ($28; CRT)
2.62
9.2
49
Oil/Gas Explor.
Enduro ($17; NDRO)
1.67
9.9
85
Oil/Gas Explor.
Hugoton Royalty ($8; HGT)
0.58
7.4
63
Oil/Gas Explor.
Sabine ($44; SBR)
2.51
5.6
50
Oil/Gas Explor.
Master Limited Partnerships
Access Midstream ($35; ACMP)
1.74
5.0
46
Oil/Gas Storage
Alliance Holdings ($50; AHGP)
2.88
5.8
67
Coal & Fuels
Alliance Resource ($62; ARLP)
4.34
7.0
77
Coal & Fuels
Blackstone ($17; BX)
0.40
2.4
49
Asset Mgmt.
El Paso Pipeline ($38; EPB)
2.32
6.1
59
Oil/Gas Storage
Energy Transfer ($45; ETP)
3.58
7.9
57
Oil/Gas Storage
Genesis ($38; GEL)
1.89
5.0
47
Oil/Gas Storage
Kinder Morgan Energy ($85; KMP)
5.04
5.9
45
Oil/Gas Storage
Plains All American ($49; PAA)
2.17
4.5
57
Oil/Gas Storage
Sunoco Logistics ($53; SXL)
2.07
3.9
82
Oil/Gas Storage
Real Estate Investment Trusts
American Tower ($77; AMT)
0.96
1.2
76
Specialized
Avalonbay Commun. ($136; AVB)
3.88
2.9
35
Residential
Equity Residential ($58; EQR)
3.07
5.3
41
Residential
Essex Property ($150; ESS)
4.40
2.9
37
Residential
Extra Space Storage ($37; EXR)
1.00
2.7
78
Specialized
Federal Realty ($105; FRT)
2.92
2.8
35
Retail
HCP ($46; HCP)
2.00
4.4
38
Specialized
Public Storage ($145; PSA)
4.40
3.0
46
Specialized
Rayonier ($53; RYN)
1.76
3.3
38
Specialized
Simon Property ($159; SPG)
4.40
2.8
51
Retail
Name (Price; Ticker)
Div.
Yield
(%)
Premium
To Call
Price
(%)
Call Date
S&P
Credit
Rating
Preferred Stocks
BB&T, 5.85% D ($27; BBT-D)
5.5
6
5/1/17
BBB
DTE Energy, 6.50% ($28; DTZ)
5.9
11
12/1/16
BBB-
HSBC, 8.00% B ($28; HCS-B)
7.2
12
12/15/15
BBB+
U.S. Bancorp, 6.50% M ($29; USB-M)
5.6
16
1/15/22
BBB+
Wells Fargo, 8.00% J ($30; WFC-J)
6.7
19
12/15/17
BBB+
Div.
Yield
(%)
Expense
Ratio
(%)
2012
Return
(%)
Bond Mutual Funds and ETFs
Fidelity High Income ($9; SPHIX)
4.9
0.76
14.9
Vanguard GNMA ($11; VFIIX)
2.2
0.21
2.4
Vanguard Inter.-Term Tax Exempt ($14; VWITX)
1.6
0.20
5.7
Vanguard Short-Term Invest.-Grade ($11; VFSTX)
1.1
0.20
4.5
Vanguard Total Bond Mkt. Index ($11; VBMFX)
1.5
0.22
4.1
SPDR Barclays High Yield ($41; JNK)
8.4
0.40
13.5
Vanguard Inter.-Term Corp. ($88; VCIT)
2.6
0.12
10.5
Vanguard Short-Term Corp. ($80; VCSH)
1.2
0.12
5.6
Vanguard Total Bond ($84; BND)
1.6
0.10
3.9
Stock Mutual Funds and ETFs
Vanguard Dividend Growth ($17; VDIGX)
2.4
0.31
10.4
Vanguard Total Int'l Stock Index ($15; VGTSX)
2.9
0.22
18.1
Vanguard Wellesley Income ($24; VWINX)
2.5
0.25
10.1
Vanguard Wellington ($34; VWELX)
2.4
0.27
12.6
ALPS Alerian MLP ($16; AMLP)
6.2
0.85
1.9
iShares S&P U.S. Preferred ($40; PFF)
6.5
0.48
18.2
SPDR S&P Dividend ($60; SDY)
3.3
0.35
11.6
Vanguard REIT ($67; VNQ)
2.8
0.10
17.6
Vanguard Utilities ($76; VPU)
4.1
0.14
1.8

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