Looking for 7% Solutions In a 4% (and Less) World
Donald Jay Korn. On Wall Street. New York: Jan 1, 2004. pg. 1
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Abstract (Document Summary)
Inflation-adjusted bonds. PIMCO's [Mark Kiesel] lists Treasury Inflation- Protected
Securities (TIPS) among his favored fixed-income holdings currently. "The market is
pricing TIPS as if inflation will be 2.4 percent a year for the next 10 years," he says. "If
inflation is higher than that, investors will be better off with TIPS than with regular
Treasury bonds." If inflation averages 4 percent for those 10 years, for example, the total
return on TIPS would be almost 6 percent per year, based on late 2003 prices. Although
TIPS can be bought directly from the federal government, there are several mutual funds
that hold TIPS.
Kiesel reports that PIMCO currently favors long-term munis, where the highest absolute
and relative yields can be found. (Insured, AAA- rated 30-year munis were yielding
nearly 5 percent recently.) "Generally," he says, "we now prefer intermediate-term
bonds. If the dollar continues to weaken, foreign investors may leave the U.S. bond
market, depressing prices. Long-term bonds could be hit the hardest. That's not a risk in
munis, though, because they're mainly held by domestic investors, so you might as well
go for the high yields on long bonds."
High-yield munis. Another way to seek higher yields in munis is to invest in low-rated or
unrated bonds. Recently, Morningstar broke out high-yield muni bond funds as a
separate category. Twenty-six such funds were identified, with an average current yield
of 5.2 percent, tax-exempt, vs. 3.9 percent for long-term muni funds.
Full Text (2761 words)
Copyright Thomson Media Jan 1, 2004
Here are some higher yielding suggestions from leading product specialists.
Interest rates may have risen a bit in mid-2003, but by year-end the financial markets
were still unyielding. Money market funds were paying a scant 0.52 percent, on average,
according to Money Fund Report, while Bankrate.com found that the average paid on
certificates of deposit ranged from 0.93 percent on six-month CDs to 3.10 percent on
five-year paper. In Treasuries, bond buyers had to go out toward 30-year maturities in
order to earn more than 5 percent.
"There is no free lunch," says Mark Kiesel, an executive vice president at PIMCO, the
investment management firm based in Newport Beach, Calif. "If you want to get more
than 4 percent or 5 percent these days, you have to take more risks." Similarly, Howard
Present, managing director for product management at Wachovia's Evergreen
Investments unit in Boston, notes, "With low yields and a high probability that interest
rates will go up, people who want higher yields have to be creative."
But demand is there. Tom Ricketts, CEO of Chicago-based Incapital, which underwrites
fixed-income securities that are sold to individual investors, says that orders of $20,000
to $25,000 are common, indicating that individuals with moderate-size portfolios are
interested in income vehicles. "Over 70 percent of our buyers are between 50 and 70
years old," he says, "so investors in that age range are most likely to be income-
seekers." In the demographics of investors, that age group is "where the money is," so it
may pay off to have a selection of investments with better-than-average payoffs.
What are some creative ways for reps to find higher-yielding holdings for clients, with
acceptable levels of risks? Consider these possibilities:
Ultra-short bond funds. "By stepping out of cash to slightly longer maturities," says Steve
Bohlin, portfolio manager of the Thornburg Limited Term Income Fund, "you can get a
significant amount of extra coupon for taking a little bit of price risk." At year-end 2003,
Morningstar, Inc. put the average yield for ultra- short funds at 2.4 percent, nearly five
times the money fund average.
"One way to receive higher yields is to accept some credit risk," says Present. "You can
invest in floating-rate senior bank loans or adjustable-rate mortgages." Funds investing
in such paper may run into problems with defaults but they also offer the prospect of
higher yields, if interest rates rise.
Present says that the Evergreen Adjustable Rate Fund, which deals in mortgages has
less exposure to rising rates than investors face with long-duration bonds. "There is
some principal risk, but the fund never has had a negative total return over a six-month
period. To help explain the tradeoffs, reps can tell clients to look at volatility over the last
10 years." This fund has enjoyed strong inflows recently, according to Present;
Morningstar puts the asset base at more than $9 billion and the current yield at over 3
percent.
Mutual funds that hold senior bank loans also are a possibility. According to Morningstar,
bank loan funds have shorter average maturities (one year) and higher yields (3.9
percent) than ultra- short bond funds.
Inflation-adjusted bonds. PIMCO's Kiesel lists Treasury Inflation- Protected Securities
(TIPS) among his favored fixed-income holdings currently. "The market is pricing TIPS
as if inflation will be 2.4 percent a year for the next 10 years," he says. "If inflation is
higher than that, investors will be better off with TIPS than with regular Treasury bonds."
If inflation averages 4 percent for those 10 years, for example, the total return on TIPS
would be almost 6 percent per year, based on late 2003 prices. Although TIPS can be
bought directly from the federal government, there are several mutual funds that hold
TIPS.
Chicago-based Incapital has begun to sell inflation-indexed corporate bonds. "They pay
interest each month, with a floating rate that's indexed to inflation," says CEO Ricketts.
"Unlike TIPS, all the interest is paid currently to investors, so our Inflation- Protected
InterNotes (IPIs) can be held in a taxable or in a tax- deferred account." Governmentissued TIPS, in contrast, generate income that's taxed currently but not received until
maturity, so they often work best inside a tax-deferred retirement plan.
Inflation-protected CDs also are available, offered by LaSalle Broker Dealer Services
Division, based in Boca Raton, Fla. "They're federally insured, up to the FDIC limits,"
says Patrick Kelly, managing director. "They're similar to TIPS, but they have more
maturity choices and a slightly higher yield: about 25 basis points on a 10-year CD."
Bond ladders. "We started laddering for the first time in a while," says John Howle, an
advisor with Raymond James & Associates and founder of the www.searchbonds.com
Web site. "Until recently, laddering had been a bad idea because clients would reinvest
at lower yields. Now, with rates so low, reinvestment risk is minimal."
With a bond ladder, maturities are staggered so that bonds mature periodically.
Redemption proceeds are re-invested at the far-out ladder rung. This technique allows
frequent reinvestment, to hedge against rising interest rates, while assembling a portfolio
of bonds bought at longer maturities, to lock in decent yields against future declines.
Bohlin suggests laddering maturities at yearly intervals, going out as far as 10 years.
"You'll pick up a lot of additional income without adding much volatility."
Investment-grade, but lower-grade. Whether or not they ladder their fixed-income
holdings, clients can earn extra yields by investing in corporate bonds rather than
Treasuries. Kelly says that investors can pick up some extra yield by going down in
credit quality but staying in the lower level of investment-grade. "GMAC SmartNotes, for
example, have been yielding 4.5 percent on five- year maturities," he notes. At the same
time, yields on five-year Treasuries were less than 3.4 percent.
"We're also seeing a great deal of demand for our floating-rate GMAC notes," he says
Kelly. "Seven-year issues, with interest rates that re-set quarterly, pay 180 basis points
over three-month Treasury bills."
Callable bonds. "Half of the nearly $20 billion worth of bonds we sold in the first three
quarters of 2003 were callable," says Ricketts. "Individual investors are not as sensitive
to the tradeoffs involved in callable bonds." One tradeoff is reinvestment risk - the
possibility of having to reinvest at lower yields should rates drop and a bond be called.
Another is price compression, which means that even though callable bondholders can
lose if interest rates rise, they can't gain much if interest rates drop because their bonds
might be redeemed at par or just slightly higher.
"We recently brought out a 10-year bond from Household International with a 5.4 percent
yield," says Ricketts. "Without the call feature, investors might have received around 5
percent."
High-yield bonds. With yields down, the appeal of high-yield bonds has gone up. Total
junk bond fund inflows for 2003 were about $25 billion, according to AMG, a research
firm in Arcata, Calif. At yearend, the average junk bond was yielding nearly 8 percent
while investment-grade corporate bonds averaged less than 4.5 percent.
"There is credit risk as well as duration risk in high-yield bonds," says Present.
"However, if the economy strengthens, the default rate on high-yield bonds likely will be
one that investors can absorb." According to Moody's Investors Service, the global junk
bond default rate had fallen to 5.7 percent in late 2003, down from a peak of 10.8
percent in January 2002.
"There is considerable disparity among high-yield bond funds, even among those with a
BB average credit quality," says Brad Sweeney, a senior analyst at Morningstar. "Some
funds hold a lot of lower quality bonds, then mix in some high-quality bonds to get to an
average of BB. Advisors need to dig in and find out what a fund holds, to learn about the
level of credit risk."
Not only the level of credit risk but the types of holdings can differentiate high-yield bond
funds. "Our Pioneer High Yield Fund is the only fund in this category that has a large
exposure to convertible bonds," says Steve Graziano, executive vice president, strategic
marketing, Pioneer Investment Management, Boston. "We have been holding 50 percent
to 70 percent of our assets in convertibles." Although this fund's recent yield (6.9
percent) was slightly below the category average (7.2 percent), its five-year annualized
return (17 percent) is by far the best in the category.
Apparently, investors and reps alike fancy the high-yield-plus- upside appeal: "Since we
bought this fund from Third Avenue Funds a few years ago," says Graziano, "its asset
base has grown from $8 million to $8 billion."
Commercial mortgage-backed securities. As the name suggests, these instruments are
made up of loans on commercial properties rather than residences. "They may be
diversified by property type and location," says Tom Marthaler, director of fixed income
at ABN AMRO Asset Management USA in Chicago. "They pay higher yields than
government-backed paper and they're not affected as much by prepayments. With
Ginnie Maes, for example, refinancing can have a larger effect on your income."
Long-term municipals. Many investors will prefer municipal bonds and muni bond funds,
which offer tax-exempt yields, to corporate bonds and funds. "Munis offer excellent value
these days, with yields that may be 90 percent of Treasury yields," says Kiesel. "Aftertax, high-bracket investors will wind up better off with munis."
Kiesel reports that PIMCO currently favors long-term munis, where the highest absolute
and relative yields can be found. (Insured, AAA- rated 30-year munis were yielding
nearly 5 percent recently.) "Generally," he says, "we now prefer intermediate-term
bonds. If the dollar continues to weaken, foreign investors may leave the U.S. bond
market, depressing prices. Long-term bonds could be hit the hardest. That's not a risk in
munis, though, because they're mainly held by domestic investors, so you might as well
go for the high yields on long bonds."
Long-, medium-, or short-term, insured municipal bonds appeal to investors seeking an
extra layer of credit risk. "For municipal bond investors who need income, I might
recommend A- and AA-rated insured bonds, which aren't widely known," says Howle.
"Two insurers - American Capital Access and Radian Asset Assurance - have lower
ratings, so the bonds they insure have slightly higher yields."
High-yield munis. Another way to seek higher yields in munis is to invest in low-rated or
unrated bonds. Recently, Morningstar broke out high-yield muni bond funds as a
separate category. Twenty-six such funds were identified, with an average current yield
of 5.2 percent, tax-exempt, vs. 3.9 percent for long-term muni funds.
"High-yield funds are less sensitive to interest rate shifts than other types of muni funds,
but they have more credit risk," says Eric Jacobson, a senior analyst at Morningstar.
"Often, these funds hold bonds with no third-party ratings. The bonds may be illiquid, so
it's difficult to know what the bonds are worth. Investors must rely on the fund manager's
skills."
Apparently, more than a few investors are willing to put their faith in the managers of
certain funds. "We've seen the best inflows we've had in a couple of years," says Jim
Phillips, co-manager of Van Kampen High-Yield Fund. An above-average tax-exempt
yield of just over 6 percent apparently hasn't hurt, either: Morningstar recently put this
fund's total assets at more than $3.5 billion.
Foreign bonds. The search for yield can be literally worldwide these days, as investors
consider bonds issued outside the U.S. "With foreign bonds," says Bohlin, "currency risk
dwarfs other factors such as credit or interest-rate risk." The U.S. dollar is generally
expected to weaken in 2004, which adds to the appeal of bonds issued in other
currencies.
"It's true that foreign bonds are really a bet against the dollar," says Sweeney, "but they
also can help to diversify a fixed- income portfolio. They have a lower correlation to
stocks than U.S. corporate bonds and they're less sensitive to interest rate movements."
Foreign bond funds yield only 3.6 percent, on average, though; funds holding bonds
from emerging markets offer yields nearly twice as high. "Emerging markets bonds may
do well in a global economic recovery, which now seems possible," says Kiesel. "Rising
commodity prices will help some of those countries. Don't overload, though. We wouldn't
have more than 5 percent of a portfolio there."
Closed-end bond funds. In many cases, closed-end bond funds offer higher yields than
their open-end fund cousins. Closed-end funds can trade at a discount or a premium to
their net asset value. When investors buy a bond fund at a discount, the yield increases.
"In addition, many closed-end income funds use leverage to boost current yields," says
Donald Cassidy, a senior research analyst at Lipper Inc. in Denver. In some cases a
fund will borrow money and use the proceeds to buy higher-yielding securities.
"Another technique," says Cassidy, "is the sale of floating-rate preferred shares to
institutions and high-net-worth individuals. The amount paid on these shares might be
much lower than the yields on the bonds bought by the fund. The spread between the
rates generates a profit that can be passed through to the common shareholders."
Such techniques can be very effective when there is a steep yield curve, as there is
today. Some closed-end muni funds now offer tax- exempt yields over 7 percent. "These
funds can be risky, though," cautions Cassidy. "If the yield curve flattens, a smaller
spread means lower profits to distribute to the common shareholders. Lower
distributions, in turn, almost surely will mean a lower trading price for a fund's shares."
Again, investors seem willing to take these risks. "We brought out three leveraged
closed-end funds in 2002 and 2003," says Graziano, "a global high-yield fund and two
municipal high-yield funds. All sold out rapidly, so we believe there is tremendous pentup demand for income-producing products."
What's more, the risks of leveraged closed-end funds may not be as great as they seem.
"Some of these funds are hedging their risks with tactics such as interest-rate swaps,"
says Graziano. "Reps should go to their firm's internal closed-end fund analyst and ask
which funds are hedging."
High yields also may be available from international closed-end bond funds, which offer
a play on the possibility of a declining dollar. Howle says that he prefers Asian funds
such as Aberdeen Asia- Pacific Income Fund. "Our analysts believe that Asian
currencies are likely to appreciate against the dollar," he says. Such appreciation would
increase returns to U.S. investors.
Foreign bonds also may play a role in multi-sector funds. Nuveen, for example, has
come out with a closed-end fund holding emerging markets sovereign debt, dividendpaying common stocks, shares in real estate investment trusts (REITs) and senior
secured loans - income-paying asset classes less sensitive to interest-rate risk than
domestic bonds.
Eaton Vance and Franklin Templeton also introduced closed-end multi-sector funds
recently, dividing their portfolios among junk bonds, floating-rate bank loans, and
mortgage-backed securities, categories deemed likely to outperform in an environment
of gradually increasing interest rates. The funds were reporting current yields north of 8
percent, as of press time.
Dividend-paying stocks. Under the 2003 tax law, most investors will pay only 15 percent
tax on dividends, while those in low tax brackets (which might include retirees) will pay a
mere 5 percent tax on dividends. "A focus on equity yields is re-emerging," says
Graziano, "especially now that investors can receive after-tax benefits. Yields in the 2
percent to 2.5 percent range may not be as sexy as dividends of 4 percent to 5 percent,
but stocks paying lower dividends might be less risky for investors."
REITS also are an equity asset class known for yield. According to data from the
National Association of Real Estate Investment Trusts, REITs generated a dividend yield
of 5.82 percent, on average, in 2003. Compound annual returns have been much higher
(35.41 percent in 2003; 13.19 percent over the past five years) due to the rise in real
estate prices.
Master limited partnerships. The good news is that many MLPs have annual payouts of
6 percent or higher. While the bad news is that those distributions won't qualify as lowtaxed dividends, most MLP distributions get favorable tax treatment. Typically, only 10
percent to 20 percent of distributions are taxed currently, with the rest of the tax bill
deferred until investors' units are sold.
Howle favors Kinder Morgan Energy Partners, TEPPCO Partners, and Inergy companies involved in transporting, processing and storing natural gas. "They offer
yields in the 6 percent to 7 percent range," he says, "but the distributions can drop."
Generally, though, such companies have performed relatively well over the past five
years.
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