Where Has the Yield Gone?
News
&
Commentary
Market Wrap
Year-To-Date
S & P 500
D.J. I.A.
3.89%
3.50%
Russell 1000
NASDAQ
4.41%
4.38%
U.S Treasury Yields
12/31/09 9/30/10
90-day T-Bill
5-Year
10-Year
0.07% 0.16%
2.66% 1.29%
3.84% 2.55%
Lending Rates
12/31/09 9/30/10
Prime Rate
3.25% 3.25%
Mortgage Rates
15-Year
4.65% 3.84%
30-Year
5.37% 4.47%
Oil
Recently, a client asked a question that
had obviously been on her mind for a
while. “Where has all of the yield
gone?” She was referring to the income
yield we had experienced over the past
10 years. Before we could answer, her
follow-up question was, “We used to
see 5% and 6% bonds, where have
those yields gone?”
points for lower yields on bonds over
the past ten years:
• Low inflation due to more efficient
•
•
In short, the yields on bonds are much
lower today with money markets and
CD’s under 1%, the 10 year U.S.
Treasury at 2.40%, AAA 10 year taxexempt bonds under 2.3% and 10 year
AA corporate bonds under 3.70%.
The drop in income yield is not new.
We have experienced steadily declining
interest rates since 1982. Perhaps the
drop in yield has been even more
pronounced over the past 10 years.
There are a great number of reasons
for lower interest rates and any on the
following list could be an essay in and
of themselves. Here are the bullet
•
•
utilization of technology
Low inflation due to the lower cost of
labor via expansion of “global
economy”
Loose monetary policy by the Federal
Reserve reacting to:
♦ Protection against potential
economic disasters such as:
Terrorist attack on 9/11 and
hurricane Katrina
♦ The strong focus by elected
leaders to allow most anyone to
own a home and borrow against
their equity
A flood of liquidity from the U.S.
Treasury and the Federal Reserve
during and after the credit crisis of
2008
Demand for what is perceived a safe
investment such as U.S. Treasuries,
high grade municipals and bond
mutual funds since the credit crisis of
2008
40 Year History of the 10 year Treasury
12/31/09 9/30/10
Per Barrel
$81.50
$81.26
Gold
Gold
12/31/09 9/30/10
$1,123 $1,316
Unemployment
12/31/09 9/30/10
Unemployment 10.0% 9.6%
Source: Bloomberg
Edition #27
September 2010
2550 University Avenue West, Suite 180 South, St. Paul, MN 55114
830 East Front Street, Suite 300, Traverse City, MI 49686
www.stonebridgecap.com
Fax: 651-251-1010
Phone: 651-251-1000
Phone: 231-933-0320
Toll-free: 800-317-1127
Where Has the Yield Gone?
Reaching for Yield
Today, investors find themselves uncomfortable with
the risks of the stock markets and are instead
reaching for yield in what they believe are safe
investments. From January of 2008 through June of
2010, outflows from equity mutual funds totaled
$232 billion while bond mutual funds have seen a
huge $559 billion of inflows. Investors are looking to
bond mutual funds as a relatively safe investment
while “reaching” for a higher yield. What investors
may not be seeing in their bond mutual funds are:
1. A steady decrease in the income yield of their bond
fund. As large cash inflows come into the bond fund,
the manager of the fund must go out and buy more
bonds at the steadily decreasing interest yields. We
recently met with a client who owns a bond mutual
fund and was surprised to see his yield go from 4.3%
to 3.8% since his last statement. Cash inflows to bond
funds have forced managers to buy bonds at steadily
decreasing yields.
2. Further, as bond fund managers buy bonds they are
compelled to attain the highest yield available and
often go out longer in maturity along the yield curve.
The longer the maturity the higher the yield, however,
going longer increases interest rate risk particularly as
we are now at the lowest yields experienced in 40
years.
Stonebridge has always argued against bond mutual
funds for all of the reasons stated above. We would
also advise investors that bond mutual funds do not
have maturity dates and fluctuate in price inversely to
interest rates. If rates rise, bond funds will drop in
value. If they rise significantly or over a period of
time, the inflows experienced over the last year could
turn into massive outflows. This would force a bond
manager to sell bonds at declining prices, resulting in
losses. Our recommendation to bond mutual fund
investors is to begin a sell strategy over the next six
months. Utilize proceeds from these sales to buy
individual bonds for the fixed income asset allocation
of your portfolio. A properly structured individual
bond portfolio with a balance of both short and
intermediate bonds can produce solid income yield
and protect against rising interest rates.
Reaching for Yield (part 2)
There are other alternatives for improving income
yield in your portfolio. It is important for investors to
assess those alternatives, carefully understanding the
opportunities as well as the risks of each.
Today, there is a new “higher yield” menu available
to investors. Before ordering off the menu, it would
be wise to know what it is that you are ordering: U.S.
Treasuries – yields are too low and AAA Corporate
bonds are boring…How about those sub-debt issues
or preferred stocks or high dividend yield common
stocks? Better yields, but you should not view these
investment alternatives in the same asset category as
money market funds or investment grade bonds.
Let’s take a look at where these securities are in the
capital structure of a company in the event of
liquidation.
Income/Dividend Yield
Form of Capital
Brief Description
Interest 0 - 1%
High grade commercial paper
.50 - 4%
Corporate bonds
First to be paid. Short term investment with stated
interest rate and maturity date.
Backed by the credit of the company. Second in line to be
paid. Stated interest rate and maturity date.
5 - 12%
Sub-debt obligations (bonds)
4 - 10%
Preferred stock
Dividend 0-6 %
Common Stock
Page 2
Backed by company assets. Paid only if commercial paper
and bonds are paid. Stated interest rate and maturity date.
It can look and act like a bond but it is a stock. Typically
has a stated dividend rate and call date (at the option of
the company) If the company cannot pay bond interest,
preferred dividends will not be paid. However, dividends
may be cumulative. There are call dates, although
depending on the structure of each issuance, the call may
be paid in cash or common stock of the issuer.
Owners of the company can vote on Corporate matters.
There may be a stated dividend paid quarterly. The
dividend may be cut or reduced in challenging financial
times. Price is more volatile than other capital issuances.
Where Has the Yield Gone?
Risk/Reward Spectrum
Commercial
Paper
Corporate
Bonds
Sub
Debt
Preferred
Stock
Common
Stock
Low Risk
High Risk
Lower
Return
Higher
Return
The risk/reward spectrum above describes the
relative risk of the different categories of corporate
capital. No matter what level you invest along the
capital structure, you must know the credit quality
of the issuer (company, government entity, agency).
Investors cannot rely on ratings from national rating
agencies. If an issuer is not able to pay interest on
its corporate bonds, it will affect the payment
stream to all lower levels of the capital structure.
Therefore, investors must understand the company,
its capital structure, debt level, profitability, cash
flow and expected performance at all capital levels
before reaching for yield.
Market Opportunities
We have experienced a rare moment in investment
history. Traditionally, common stocks outperform
bonds over a market cycle and have over the long
term. However, over the past 10 years of declining
interest rates, bonds have outperformed common
stocks by an annual average of 2 – 4%. As we stated
previously, investors continue to pour money into
bond mutual funds for the presumed safety and
recent investment performance. Given where we
are economically in this market cycle, where are the
best values for investors? Bonds, gold, real estate?
We would submit that common stocks of financially
strong companies offer significant value at this stage
of the economic cycle.
Why?
Economic Cycle: Although it may not feel like the
recession is over to investors, we are in the
beginning stages of a recovery and we do not
believe we are headed into a double dip. We do
believe that the U.S. economy will experience slow
economic growth, low inflation and a continuance
of both the consumer and corporations repairing
their balance sheets.
Market Cycle: At this stage in the market cycle,
companies have been repairing their balance sheets
by significantly reducing their debt and building
cash. As of June 30, 2010, corporate cash exceeded
$1.84 trillion. According to Standard & Poor's, 299
companies raised their dividends during the 3rd
quarter, a 56% increase over the same period last
year. Stock buy backs are also on the rise. Even
more important, mergers and acquisitions have
taken a big jump in the 3rd quarter, an indication
that companies see value in acquisitions and have
capital to put to work.
For investors who are seeking income yields
coupled with growth, the S&P 500 Index offers a
dividend yield of 2.5% as compared to the U.S.
Treasury of 2.4%
Page 3
Market Opportunities
High Dividend Yield Investment Strategy
A high dividend yield strategy can provide a
current dividend income yield that exceeds U.S.
Treasuries and high grade corporate bonds. This
strategy is a long term investment strategy
designed to provide income and growth of capital.
It should not be considered a bond alternative. It
can offer higher yields than bonds but will be
volatile in price and there is no maturity date.
The current low inflation, low growth economy is
an economic catapult for companies with low
debt, reasonable growth of revenue, strong cash
flow and solid profits. The companies that we
follow have significantly reduced debt over the
past few years and are sitting on a mountain of
cash. Many use this cash to increase dividends, as
is the case for Cisco, McDonalds and Microsoft
which recently announced dividend increases.
Our strategy for identifying long-term high
dividend yield companies is outlined below:
• Seek dividend yields of 3% or higher
• Identify companies with a history of consistent
and/or growing dividend payouts
• Companies must have:
♦ Low debt to equity ratios
♦ Solid cash flow
♦ Reasonable revenue growth
♦ Consistent
profitability with reasonable
payout ratios
• Portfolios must be diversified across sectors and
companies (preferably no more than 5% in any
one company)
Examples of companies that may be utilized in
this strategy include:
Name
Industry
Current Dividend
Yield
Bristol-Meyers Squibb
Healthcare
4.6%
H.J. Heinz
Foods
3.8%
McDonald’s Corp.
Restaurants
3.0%
Microchip Technologies Information Tech
4.5%
We believe now is the right time in this market
cycle to acquire high quality – high dividend
yielding common stocks to benefit from a
dividend yield that exceeds U.S. Treasuries and
provides the opportunity for long term growth.
Reaching for Yield
At a time when investors are tempted to “reach
for yield”, it is important to understand why the
yield is higher. Make sure you understand the
security, capital structure, growth rate, cash flow
and evaluate the issuers ability to pay the dividend
or interest payments. Also assess the risk vs.
reward and where the security fits into your asset
allocation balance.
For information regarding high yielding securities,
please contact us at (800) 317-1127 or
rkincade@stonebridgecap.com.
• We prefer companies that are leaders in their
industry with successful results and driven
management teams
Stonebridge Capital Advisors serves the investment needs of high net-worth individuals, insurance companies, retirement plans, endowments and foundations with
customized, separately managed portfolios. Our specialized portfolio management services include Large Capitalization Growth Equity, Tax-Exempt Fixed Income
and Taxable Fixed Income. Please give us a call for more information on how Stonebridge Capital can meet your investment objectives (800) 317-1127.
Page 4
2550 University Avenue West, Suite 180 South, St. Paul, MN 55114
830 East Front Street, Suite 300, Traverse City, MI 49686
www.stonebridgecap.com
Fax: 651-251-1010
Phone:
651-251-1000
Phone:
231-933-0320
Toll-free: 800-317-1127