bonds …a threat to stocks?

I read an odd article in the Wall Street Journal yesterday, an opinion piece that in the US bonds are a current threat to stocks.  Although not explicitly stated, the idea seems to be that the US is in the grip of cult-like devotion to stocks.  One day, however, after a series of Fed monetary policy tightening steps, the blinders we’re wearing will drop off.  We’ll suddenly see that higher yields have made bonds an attractive alternative to equities   …and there’ll be a severe correction in the stock market as we all reallocate our portfolios.

What I find odd about this picture:

–the dividend yield on the S&P 500 is just about 2%, which compares with the yield of 2.3% on a 10-year Treasury bond.  So Treasuries aren’t significantly more attractive than stocks today, especially since we know that rates are headed up–meaning bond prices are headed down.  Actually, bonds have been seriously overvalued against stocks for years, although they are less so today than in years past

–from 2009 onward, individual investors have steadily reallocated away from stocks to the perceived safety of bonds, thereby missing out on the bull market in stocks.  If anything there’s cult-like devotion to bonds, not stocks

–past periods of Fed interest rate hikes have been marked by falling bond prices and stock prices moving sideways.  So stocks have been the better bet while rates are moving upward.  Maybe this time will be different, but those last five words are among the scariest an investor can utter.

 

Still, there’s the kernel of an important idea in the article.

At some point, through some combination of stock market rises and bond market falls, bonds will no longer be heavily overvalued vs. stocks and become serious competition for investor savings.

Where is that point?  What is the yield level where holders of stocks will seriously consider reallocating to bonds?

I’m not sure.

Two thoughts, though:

–I think the typical total return on holding stocks will continue be around 8% annually.  For me, the return on bonds has got to be at least 4% before they have any appeal.  So the Fed has a lot of interest-rate boosting work to do before I’d feel any urge to reallocate

–movement in yield for the 10-year Treasury from 2.3% to 4.0% means that the price of today’s bonds will go down.  So, while there is a clear argument for holding cash during a period of interest rate hikes, I don’t see any for holding bonds–and particularly none for holding bonds on the idea that stocks might fall in price as rates rise

Of course, I’m an inveterate holder of stocks.  And this is an interesting question to ask yourself.  What yield on bonds would make them attractive to you?

 

 

a steadily rising Fed Funds rate into 2019

That’s the thrust of Fed Chair Janet Yellen’s remarks yesterday about rates in the US.

She said that there would be “a few” increases in the Fed Funds rate in each of 2017 and 2018.  Assuming that a few = three and that each increase will be 0.25%, Yellen’s statement implies that the rate will rise steadily until it reaches 2.0% sometime next year.

In one sense, two years of rising interest rates sounds like a lot–I know that’s what I thought the first time I was facing this prospect as a portfolio manager.  But if the neutral target rate for overnight money is the level that achieves inflation protection but no real return, 2% should be the target.  If anything, it’s a bare minimum.

In my view, two surprises to the Yellen forecast are possible:

–if President Trump is able to launch a significant fiscal stimulus program, the rate rise timetable will likely be accelerated, and

–if the inflation rate rises above 2%, which I think is a good possibility, then the Fed Funds rate may need to rise above 2% (2.5%?) to keep inflation in check.

Typically, a time of rising rates is one in which stocks–buoyed by increasing corporate earnings–go sideways, while bonds go down.  In the present case, earnings growth will likely depend on an end to dysfunction in Washington.

 

 

refinancing/repricing bank loans

One way that an investment bank can win merger and acquisition business is to offer financing to bidders through what are called bank loans.  These are essentially long-term corporate bonds that carry high variable-rate coupons based on libor.   The successful bidding company issues them to the bank to pay for an acquisition.  The bank resells the loans to institutional investors.

There has been strong interest in such loans over the past couple of years for two reasons:  yielding, say libor +4%, they offer high current yields; and, at least in theory, there’s the possibility of rising income as libor increases.  Some of these bonds have the further fillip that the variable (libor) portion can’t go below a fixed amount, say 1%, no matter what the actual libor rate is.

Three-month libor is now approaching 1%, up from as low as 0.2% in 2015.  This benchmark rate is certainly heading higher.

Fro the perspective of holders, one flaw with these bank loans, however, is that they offer little call protection.  What’s now happening on a massive scale is that banks are approaching institutional customers who bought high-yielding bank loans and offering to replace a loan yielding, say,  libor +4% with an equivalent loan from the same borrower yielding libor +3%.

Customers are taking up such deals in droves.  How so?  Technicially, the original loan instruments are being called, meaning the issuer is exercising its right to pay the loans off at par.  The customer can either get his money back in cash–and therefore be forced to find a new place to invest the funds–or accept payment in a new, less lucrative, loan.

The customer has two incentives to take the latter:  the new terms are still attractive; and the borrower will have developed deeper confidence in the issuer through continuing study of company operations and a history of on-time coupon payments.

 

The real winners here are the banks, who collect another round of fees for providing this service. In all likelihood, this won’t be the last round of repricing, either.

 

interest rates: how high?

the speed of interest rate rises

The best indicator of how fast the Fed will raise the Fed Funds rate will likely be the pace of wage gains and new job creation, as shown in the monthly Employment Situation report issued by the Bureau of Labor Statistics.  Infrastructure investment legislation that may be passed by the new Congress next year may also factor into the Fed’s thinking.  On the other hand, the continuing example of Japan, whose quarter-century of no economic growth is due in part to premature tightening of economic policy is also likely to play a part in decision making.

Much of that will be hard to be certain about in advance.  Current Wall Street thinking, for what it’s worth, is that the pace will be north of glacial but not fast at all–maybe a move of +0.50% next year, after a boost of +0.25% later this month.

The endpoint of policy, however, may be somewhat easier to forecast.

the final policy goal

 

Fed policy is aimed at holding inflation at +2.0% per year.  Its main problem recently is that it can’t get inflation that high, in spite of having flooded the economy with money for the past eight years.  So let’s say we’ll have inflation at 2%, but not higher, some time in the future.

cash

If so, and if the return on cash-like investments during normal times continues to provide protection against inflation and little else, then the final target for the Fed Funds rate is 2%.

bonds

If we consider the 30-year bond and say that the normal annual return should be inflation protection + 2% per year, then the target yield for it would be 4%–vs slightly over 3% today.

The 10-year?  subtract 50 basis points from the 30-year annual yield.  That would mean 3.5% as the target yield.

If this is correct, the important thing about the domestic bond market since the US election is the substantial steepening of the yield curve.  While cash has another 150 bp to rise to get to 2%, the long bond is within 100bp of where I think it will eventually settle in.

In other words, a substantial amount of readjustment has already occurred.

 

 

 

 

 

 

REITs when interest rates are rising

Finally, to the question of REITs (Real Estate Investment Trusts).

A REIT is a specialized type of corporation that accepts restrictions on the kind of business it can do and limits to how concentrated its ownership structure can be.  It must also distribute virtually all its profits to shareholders.  In return it gets an exemption from corporate income tax.  It’s basically the same legal structure as mutual funds or ETFs.

Traditionally, REITs have concentrated on owning income-generating real estate.  But they are also allowed to to develop and manage new projects, provided they do so to hold as part of their portfolios instead of to resell.

Because they must distribute basically all of their profits, and to the degree that their property development efforts are small relative to their overall asset size, REITs look an awful lot like bonds.  That is to say, their main attraction is their relatively steady income.  Yes, they hold tangible assets of a type that should not be badly affected by inflation.  But current holders, I think, view them as bond substitutes.

As I suggested in Monday’s post, that’s bad in a time of rising interest rates.  Both newly-issued bonds–and eventually cash as well–become increasingly attractive as lower-risk substitutes.  This is the reason REITs have underperformed the S&P by about 5 percentage points so far this month, and by 9 points since the end of September.  I don’t think we’ve yet reached the back half of this game.

How can an investor fight the negative influence of interest rate rises in the REIT sector?   …by finding REITs that look as much as they can like stocks.  That is, by finding REITs that are able to achieve earnings–that therefore distributable income–growth.

This means finding REITs that can raise rents steadily or whose development of new properties is large relative to their current asset size.

 

stocks vs. bonds when interest rates are rising

A regular reader asked what I think about REITs in a comment last Friday.  I thought I’d answer him here, starting in a more general way.

One of the safer conclusions we can draw from the US election results is that interest rates are going to be rising over the next couple of years.  Most likely this will happen at a more rapid rate than under the Washington gridlock scenario a Hillary victory would probably have perpetuated.

Two reasons:

–the US appears to be at or near full employment, as evidenced by recent wage gain acceleration, so rates would be rising to fend off future inflation in any event, and

–Republicans, who have been blocking Obama’s infrastructure spending proposals (for no good economic reason), are in favor of fiscal stimulus now that they will get the credit. This will remove some of the pressure the Fed is now under to compensate for congressional failure to do its part to restore economic stability.

 

What happens to stocks and bonds as rates go up?

cash

— a point of merely academic interest right now, but something to tuck away in the back of our minds, there could come a time when the returns on cash are high enough to draw money to it that would otherwise have gone to stocks and bonds.  I don’t know what that point might be, just that it’s a long time away.  The question to answer is:  if the expected return for stocks is 8% a year and I can get, say, 4% in a savings account, am I willing to take the greater risk of owning stocks?

government bonds

–if we take the simplest case, a government bond is a high-quality promise (i) to pay a specified amount of interest for a set period of time, and (ii) to return the principal at the end of the bond’s term.

The annual return on a bond should be the return on cash + a premium to compensate for tying one’s money up for a long period of time.  At the moment, the rate for a 10-year Treasury bond is about 2.16%.  That compares with, say, 0.5% for overnight money.

Suppose the rate on overnight money rises to 2.0%.  A newly-issued 10-year would likely have to yield at a minimum, say, 3.25% to draw buyers (yes, the time premium normally fades as rates rise).  This implies that an already-existing 10-year yielding 2.16% must be worth less than par (since the going rate for a bond at par is 3.25%).

In other words, as interest rates go up, the value of an existing bond goes down.  There’s nothing the issuer can do to change that dynamic.  Since the issuer has the use of what is now cheap money, he will presumably have no desire to change it, either.

 

More tomorrow.

the Fed in 1994

Maybe there’s nothing in past Fed rate raising actions that’s strictly comparable to the situation today.  However, the period that’s most often cited as a possible model is the one from May 1994 through February 1995.  During that time the Fed raised rates by a total of +2.25% in four moves–May, August and November 1994 and February 1995.

the Fed in 1994-95

The Fed moves themselves, and the stock market responses, played out as follows:

–the Fed Funds rate remains constant at 3.75% throughout 1993, a period when the S&P 500 rises by 9%

——–from the market high on January 28, 1994 through May 13th     S&P falls by -10%

May 17, 1994, Fed raises the Fed Funds rate by 0.50% to 4.25%

——–S&P 500 rises by 4% from May 17 through August 16

August 16, 1994, Fed raises the Fed Funds rate, again by 0.50%, to 4.75%

——–S&P 500 is flat from August 16 through November 15

November 15, 1994, Fed raises Fed Funds rate by 0.75% to 5.50%

——–S&P 500 rises by 4% from November 15 through February 1, 1995

–February 1, 1995Fed raises the Fed Funds rate by 0.50% to 6.0%–and stops

——–S&P 500 rises by 29% through yearend 1995.

the pattern

aggressive rate increases every three months, totaling 225 basis points

the S&P 500 falls in ahead of the onset of rate moves, wobbles briefly as rates are raised, goes sideways/up until the next rate increase–and advances strongly once the Fed stops

relevance for today?

Entering 1994, real GDP in the US was growing at about a 5% annual rate (or about two percentage points above the maximum sustainable growth rate)–and accelerating.  So the Fed acted very quickly to slow the economy down.

We’ve got a very different problem today.  Growth is barely at trend.  Expansionary monetary policy has been exhausted, and has overstayed its welcome simply getting us to this point.  Washington has consistently failed to use fiscal policy to support GDP growth, and shows no signs of wanting to live up to its responsibilities.

The purpose of Fed Funds rate increases this time is to minimize economic distortions that happen when too much money is sloshing around in the system (think:  oil and gas junk bonds with no restrictive covenants), rather than to slow down runaway growth.

In 1994, the S&P sagged significantly in advance of the Fed’s initial move.  The index also stumbled slightly around the time of later rate increases.  But, apart from day-to-day wiggles, the index went sideways to up during the rate rising period.

Did the Fed design its rate behavior with an eye to keeping the stock market stable back then?  That’s not clear.  However, that certainly was what resulted from Fed action.  And avoiding stock market declines was clearly Allen Greenspan’s modus operandi in the Fed’s subsequent rate policy.

Today’s Fed has been quite explicit in its intention to avoid market turbulence that might occur were rates to rise too fast.  1994 shows us, I think, that it can accomplish that objective.  The Fed already seems to be signalling that its original plan to raise rates by 100 basis points this year is being revised downward.

That period also suggests that the major stock market adjustment comes very early in the process.  Arguably, that’s what the declines of August-September and November-January are all about.