Another Day, Another Euro Crisis

Of the many ways in which Silvio Berlusconi thought he could be forced from power, rising Italian bond yields was probably not high on his list. Even his titillating escapades seemed to have been insufficient to persuade the Italian electorate he should leave. But it turns out 7%+ bond yields, with €300Bn of new borrowing required in 2012, is the the breaking point. Less than a month ago the focus was on Greece and building a secure firewall with the EFSF to prevent contagion spreading to Spain or Italy. Now here we are, and we’re running out of unthinkable developments.

It’s not that Europe doesn’t possess the savings to fund profligate countries while they adopt the German fiscal model. It’s just that the money is in the wrong place – northern Europe not Southern.

So another test of equity investors’ fortitude looms. The S&P 500 (SPY) will once again shift from greed to fear. But it’s always worth looking at the fundamentals of the companies you own. For example, in our Hedged Dividend Capture Stategy, McDonalds (MCD) reported 5.5% Year-on-Year sales growth in restaurants open more than a year. Even in Europe sales grew 4.8%. It yields 3% (more than 1% over ten year U.S. treasuries) and could grow earnings at 10% next year. Kraft (KFT) just revised up their 2011 guidance from $2.25 to $2.27 and continues to exploit synergies from their Cadbury’s acquisition. KFT is also likely to grow at double digits as it prepares to break itself up into two companies and yields 3.3%, more than 1.3% over ten-year U.S. treasuries. The Federal government wants your tax dollars, but really doesn’t want your savings. That’s the message of today’s bond yields.

The near term is usually uncertain, and especially so right now. But the prospects of these and other companies remain solid.

The End of Interest Rate Risk

Larry Hirshik is both a good friend of mine and our talented trader at SL Advisors. We’ve been friends for over 25 years. Larry and I both spent many years trading interest rate derivatives – eurodollar futures, interest rate swaps and government securities. Interest rate risk has been a topic that consumed much of our intellectual energy for close to three decades. Analyzing economic data, extrapolating growth prospects and assessing the likely path of the Federal Funds rate and interest rates in general was an important part of what we did.

So my friend Larry, who often possesses market insight, noted that there is no longer interest rate risk. Every fixed income analyst is really a credit analyst. As I considered this slap at orthodoxy, I realized Larry was on to something. The Fed has promised zero interest rates through at least 2013, and keeps coming up with new, innovative ways to lower bond yields. Almost every developed country has a policy designed to keep bond yields low enough to shoo away all but the least discriminating investor. The dominant issue affecting the cost of credit for almost the entire world is now its own creditworthiness. European sovereign debt yields are approaching or have already crossed high yield. And so it comes to this – 10 year Italian government bond yields, over 6%, are now competing with si,ilarly yielding leveraged loans. Given the choice between a portfolio of senior debt from non-investment grade corporations, or government debt from an issuer whose yields are now so far above nominal GDP growth as to ensure its debt load is unsustainable, investing in the former seems a wholly more sensible idea. Add this to the “Strange World” list.

Thirty Years of Hurt

It’s not just the last decade that’s been harsh on stocks. A report from Jim Bianco’s eponymous research company calculates that for the past thirty years treasury bonds have outperformed stocks. It’s the first thirty year period since 1861 that this has happened according to research on the topic by Jeremy Siegel.

What could be safer than to bet on a continuation of a thirty year trend? Most of the people working on Wall Street have lived the majority of their careers during a time when safe, stodgy investments have been the place to be – though it should be added that the relatively long duration of thirty year bonds makes their price moves more perky than shorter maturities. But the very success of bond investing makes it that much harder to repeat the performance. Just as stocks had impossibly high P/E ratios in the late 90s as the internet bubble climaxed, ten-year treasury notes yielding 2.2% can only return 2.2% over the next ten years. Thirty year bonds returned 11.5% over the past thirty – the yield on thirty year bonds thirty years ago was 14.68% (according to the Federal Reserve’s H-15 report) which accounts for their subsequent return. Today’s thirty year bond yields 3.25%. As mysterious as is the Math of fixed income to some, even Bernie Madoff couldn’t conjure up past returns out of today’s yields.

No doubt for some time to come bonds will be the beneficiary of investors. The world remains a financially risky place, and the latest EU crisis measures increasingly appear to be short of what’s needed. Wilbur Ross was on CNBC this morning noting that a 50% writedown in all EU peripheral sovereign debt (i.e. the GIPSI countries) would require an additional €400BN in bank capital compared with the EBA’s current stress-test estimate of €100BN (of which €30BN is for Greek banks). Other analysts are increasingly finding fault with the absence of detail in the plan. There continues to be plenty for investors to worry about. And yet, stocks don’t require much dividend growth to outdeliver bonds. $20 in 2% yielding stocks with 4% growth provides the same return as $100 in 2% yielding ten year treasuries, leaving $80 to be held in cash or invested elsewhere. Stocks have had a great October and cheaper entry will be available. But the math is compelling.

There have been many times when the ultimate high in the bond market could have occurred – however, one can be certain that past performance will not predict future returns. One can be reasonably sure that future returns will be very low single digits. And there’s a decent chance that today’s bond investors will lose money. Safety comes with a price.

Another Problem with Low Rates

The Federal Reserve’s wealth transfer strategy of shifting purchasing power from savers to borrowers has other unintended consequences apart from plundering the thrifty in favor of the profligate. If you run a fixed income fund, ten-year treasury notes with a 2% handle doesn’t create much raw material from which to manufacture some income for your clients. The inadequacy of the yields jumps out, and many thoughtful bond managers have been drawn, or even forced, to reject such poor compensation and to adjust their positions in anticipation of fairer, higher yields.

Thus has the Pimco Total Return Institutional Fund (PTTRX) missed this year’s rally in bonds. Having concluded earlier in the year that U.S. treasury yields offered scant return for the risk, they shunned them publicly and completely through the debt ceiling crisis and into the most recent bout of risk reduction in the third quarter. It was a completely reasonable view to take – they may not have drawn comfort from the fact that we shared their outlook, but we did and so this article is not about bragging that we outperformed Bill Gross. Pimco’s long track record speaks for itself. The point here is that artificially low yields perhaps added urgency to the quest for better fixed income outcomes than were on offer for a passive investor. Positive real yields of, say, 2% (which would require interest rates 1-2% higher) at least afford the plausible option of passively investing and taking what’s on offer. But since today’s yields reduce purchasing power after taxes and inflation, any red-blooded bond manager is virtually required to shop around for alternatives. For a bond fund as big as PTTRX the bets are necessarily big. Their boycott of the U.S. treasury market caused them to miss a fall in yields from simply ruinous to ridiculous.

Just because a view has been wrong is not sufficient reason to change it. That statement doesn’t apply to traders with leverage, since holding one’s convictions too strongly can lead to bankruptcy. But for the unleveraged, new information is the only thing that’s really important. Bond yields have fallen this year and being underinvested has been wrong – so far. But the new bond yields are less attractive than the old ones, and while economic growth has moderated in recent months  the long-term outlook is scarcely that much worse than in the Spring. Active government involvement in the bond market is designed to drive other investors away. Ben Bernanke could as easily hold up a sign during his regular testimonies before Congress saying, “Savers, We Don’t Want Your Money”. What can be more eloquent than the active competition of the government with private savers for its own debt? How loudly should the message be broadcast? If the government wants bonds that badly, let them take the lot. Go elsewhere – senior loans, Master Limited Partnerships, dividend-paying stocks. The government wants savers to consider such alternatives, and will continue to drive them out with derisory yields until they get the joke.

Meanwhile, Bill Gross wrote a rare mea culpa. Well put, and you’ll find no criticism of his past actions here. Pimco have more recently completely switched gears on treasuries and now own them – in fact, if anything based on the aforementioned letter Pimco’s economic outlook is more negative than consensus. Retaining the mental flexibility to move 180 degrees from bearish to bullish is extraordinarily difficult. Most people can only manage moving back to neutral, so kudos to Bill Gross for not letting a few dropped fly balls cause him to lose his nerve. I can’t claim such dexterity – or more accurately, I continue to believe far better alternatives to bonds exist.

If you had more money than you knew what to do with…

So says Don Sturm, owner of two community banks in Colorado. And Mr. Sturm’s complaint is not that he’s been amply paid (although he may have), but that depositors are flooding in at a rate that outstrips his banks’ ability to usefully redeploy the money. This is QE2 at ground level. Investors fleeing the treacherous equity markets are selecting safe bank deposits, but are receiving nothing in return. In some cases banks are actually charging large clients for the privelige of being depositors.

Banks are still struggling to find enough good places to put the money they have. Although the system is awash with liquidity that other necessary component of inflation which is velocity (in other words, how quickly money gets recycled) is notably absent. Hence the ballooning money supply is not yet translating into inflation. But M2 is growing at an increasing pace – according to figures from the Federal Reserve its annualized growth has quickened from 10% over the past year to 24% over the past three months. Still no sign of a problem, and yet ten year treasury notes yielding 2.25% or high grade corporate debt at just over 4% provide scant protection should money velocity reappear and link up with already ample money creation.

On a different topic, how exactly does an investor in Greek debt get comfortable with a “voluntary” 60% loss? To accept any negotiated settlement there needs to exist a worse alternative, and it’s hard to imagine what that might be. Since the purpose of a voluntary loss is to avoid triggering a payoff on CDS contracts, it’s a stretch to see why any holder of Greek debt who also owned such CDS insurance would accept an uninsured 60% loss rather than endure a bankruptcy and so retain the ability to claim on their insurance coverage. Maybe there are very few holders of CDS who use it to insure against risks they already have. It increasingly appears as if most buyers of CDS protection were smart enough to avoid actually needing the insurance. It’s as if most homeowners insurance was owned by people on their neighbour’s house rather than their own.

We continue to be short the Euro through a long position in EUO. Although Europe’s leaders are clearly focused on the issues at hand, the latest recapitalization needs are being dismissed by analysts as simply covering the loss from a mark-to-market of existing bond holdings at current levels rather than simulating a more stressful scenario than currently exists. The EU’s leaders are getting there but at a painfully slow rate, and southern Europe is most likely already in a recesson. As is often the case, it looks as if the economic cycle in  the U.S. will be ahead of Europe’s, which should provide support for the $ against the €.

Monday Morning Thoughts, October 24th

There’s an interesting article in the Wall Street Journal highlighting that banks are increasingly the first source of funds for takeovers – providing more funds that the high yield bond market. Kinder Morgan’s recent acquisition of El Paso is cited as an example, but there’s increasing evidence that banks are increasing their risk appetite. The Fed’s confiscatory interest rate policies are steadily squeezing people out of riskless assets where there’s no return to be made. In our Fixed Income strategy we continue to own senior loan closed end funds such as Blackrock Defined opportunity Fund (BHL) and ING Prime Rate Trust (PPR). The prices on this sector had dropped more than 20% over the past six months, through lower NAVs and prices shifting from a premium to a discount.

Hedge funds are nervously waiting – not for the publication of my book, The Hedge Fund Mirage, but instead to see how big redemptions are going in to the end of the year. The WSJ has an article noting poor performance by some very large funds (Paulson, Maverick and Kingdon amongst others). Hedge fund investors are apparently maintaining their strategy of momentum investing even though it has served them so poorly over the years. Adding to winners and redeeming from losers. There aren’t many hedge fund investors who seek out under-performing managers.

We invested in Transocean (RIG) on Friday in our Deep Value Equity strategy. We had previously owned the largest owner of offshore oil rigs last year following the Gulf of Mexico oil spill when its stock traded down substantially on fears of enormous legal liability. Such fears were unfounded and the stock recovered. We exited although well before its high. In recent months concerns of economic slowdown as well as BP’s lawsuit have depressed the stock price which is now trading more than 30% below the market value of its rigs (according to research from JPMorgan). There’s considerable room for error around such estimates, but this provides a greater margin of safety than on other names in its peer group. In addition with consensus estimates for $5.26 per share in earnings next year it appears attractively priced. BP’s lawsuit will no doubt continue to be a cloud over them for some time, but with $17BN in market cap and $25BN in enterprise value they’re big enough to handle even a $1BN legal settlement. It also pays a $3.16 dividend which gives it a yield of almost 6%.

We continue to own Gannett Co (GCI). It has been an unrewarding experience so far. It’s true they’re in the hated newspaper business which continues to shrink every quarter, but they also own broadcasting and digital franchises which look much more attractive. The problem is their publishing division is their biggest, notably the newspaper USA Today. But they are consistently profitable and trade at less than 6X earnings which are expected to grow modestly next year (helped by election-related TV advertising and continued double-digit growth in their online businesses). We’d like to see them buy back more stock but cashflow from operations regularly exceeds $700 million per year (compared with their market cap of 2.7BN), and with minimal capex needs they’ve been paying down debt. Perhaps the improved lending climate noted above will induce a private equity buyer to acquire what we think is a very cheap company.

Disvlosure: Author is Long BHL, PPR, RIG, GCI

Are Dividend Paying Stocks Expensive?

Barron’s over this past weekend included an article warning that dividend paying stocks were getting expensive. Author Michael Santoli cited recent work from Vadim Zlotnikov at Bernstein Research comparing price/book valuations on low beta and high beta stocks. On this basis low beta stocks are at the 99th percentile of valuation (i.e. expensive) over the past 50 years, whereas high beta stocks are at the 6th percentile. Low beta stocks don’t have to be the same as high dividend yield stocks, although there tends to be a good deal of overlap. The kind of business that can pay a reliable dividend that grows predictably tends also to have less volatile earnings, so it makes sense for the two categories to overlap. Pro-cyclical businesses with high earnings volatility pay low (or no) dividends, conserving cash for less certain times.

Companies that we include in our Hedged Dividend Capture Strategy include boringly predictable names like Chubb Corporation (CB),Kraft (KFT),  Procter and Gamble (PG) and AT&T (T). Annual dividend increases of  6% or more are not uncommon among names like these over many years, and they all offer dividend yields that are competitive with high grade bonds (and much more attractive than treasuries). As the future increasingly looks as if it will not provide a fair return to traditional investors in fixed income, investors have been finding other sources of income and dividend paying stocks have been a beneficiary. BernsteinResearch invariably produces high quality work that is supported with reams of data. The increasing price/book multiple paid by investors for such names could indicate that they’re becoming relatively expensive, although the wide equity risk premium suggests that stocks are not that expensive compared with bonds using 40 years of data. If you go back a really long way however, Vadim Zlotnikov notes that over 140 years it’s not quite so compelling.

But the performance of dividend paying stocks has coincided with falling interest rates, and bond yields are similarly at or close to their 99th percentile of overvaluation by any measure this side of World War II. Such names can be owned as a long-only portfolio or with a market hedge so as to be beta neutral, but the possibility of getting yield with an “equity kicker” appears increasingly compelling.

The Tyranny of Low Rates

Ultra low interest rates may be the Fed’s best bet at preventing the economy from sliding into another recession, but for savers they represent a stealthy attack on the real value of savings. Money market funds barely pay anything at all, and even ten year high grade corporate bonds only yield 4%. After taxes that leaves very little real yield (i.e. after inflation) and no compensation for the risk of rising rates or any increase in default risk. In fact it would only take a 0.5% increase in long term rates to cause a sufficient capital loss in ten year bonds to wipe out a year’s worth of income. The fact that the Fed combined their announcement of Operation “Twist”, (buying long term bonds and selling shorter maturities) with an expression of concern over the U.S. economy was enough to trigger another round of risk aversion and a flight into the very bonds the Fed is trying to make unattractive.

The tyranny of low rates is the regime facing fixed income investors everywhere. High grade bonds have returned around 6% per annum over the past decade and have done that much just through the first nine months of 2011. But with yields at 4%, it’s pretty clear that the only way to repeat past performance is for yields to drop even further than they are now. A 1% drop in bond yields would cause around a 9% jump in prices, but the economic environment required to drive yields so low is unlikely to be friendly to many types of corporate risk.

There are alternatives. Investors should seriously consider reducing their conventional fixed income allocations. In any event, most balanced accounts will be below target on equities and above target on bonds following the sharp sell of in global stocks during the 3rd quarter. Rebalancing is generating bond sellers and stock buyers. But while this may push long term rates up a bit, the Fed is unlikely to contemplate raising short term rates until at least 2013.

As a substitute for bonds, we have three suggestions. Master Limited Partnerships (MLPs) pay distributions of around 6% and are likely to grow those distributions at 4-5%  over the next year. It’s enlightening to read through the public filings. One of our holdings in Magellan Midstream Partners (MMP). The tariff increases on pipelines  that cross state lines are controlled by the Federal Energy Regulatory Commission (FERC) and annual rate hikes are linked to the PPI-FG (Produce Price Index for Finished Goods). Regular price increases linked to inflation are part of the reason MLPs can grow their distributions so steadily. MMP for example hiked prices on its pipeline network that runs down the center of the U.S. from Minnesota to Texas by 6.9% in July. MMP also provides an interesting way to benefit from the growing use of domestic natural gas in the U.S. since they continue to expand in areas rich with shale gas.

Barrons regularly writes about MLPs – a recent article highlighted the attraction of the sector.

Another place of refuge from low interest rates is a combination of cash and stocks. It needn’t be as reckless as it sounds. The math can be quite compelling. Using ten year treasury notes which currently yield around 2% as an example: a taxable investor’s $100 investment would grow to $113 after ten years. The same $100 could be allocated 80/20 between riskless three month treasury bills and large cap stocks. Putting only $20 into  2% dividend yielding stocks combined with a very modest 4% growth in dividends would also result in $113 of value in  ten years. But this includes some very cautious assumptions – dividends ougfht to grow faster than 4%. They’ve grown at 5% over the past 50 years and companies are paying out a smaller share of their profits than in the past because it’s more tax efficient to buy back stock or reinvest back in their businesses.  And the $80 in treasury bills in this example may not pay any interest today but holding cash preserves flexibility to invest later when the future appears clearer or interest rates are higher. We’ve been discussing this strategy with clients. In effect the unusually high equity risk premium, the difference between the earnings yield on stocks and the interest rate on treasury securities, is making this possible as investors afraid of a repeat of 2008 seek safety in bonds.

Finally, it can be attractive to own a diversified portfolio of dividend paying stocks hedged with a short position in the S&P500. Stable earnings typically allow steady dividends, and such companies often have less volatility in their businesses and their stock prices than the market as a whole. $100 invested in dividend paying stocks can be made market neutral with around a $50 short position in an ETF such as SPY, hedging against short term price fluctuations but still allowing the investor to earn dividends and participate in dividend growth.

The Fed is making fixed income an unattractive hiding place. Prudent alternatives exist that offer the prospect of higher income with acceptable levels of risk.

The Sorry Math of Bonds

The equity risk premium (as defined as the earnings yield on stocks minus the yield on the ten year treasury note) is wide for good reason. 2012 consensus earnings for the S&P 500 of $105, which implies an earnings yield of 9.3% (September 30 S&P 500 at 1131) and a spread over the 1.90% yield on the ten year treasury of 7.4% is wide by any measure. It last reached these levels in 1973, during the Yom Kippur War and the OPEC oil embargo. Today’s problems are different and maybe far worse. An assessment probably depends as much on whether one’s philosophy of life is optimistic as on how the macro issues will play out. For our part, we are cautiously constructive and maintain equity exposures at neutral, believing that current valuations offer a sufficient discount for the risks.
While respectable cases both for and against equities can be made, the absence of value in bonds seems far less contentious. No doubt for most of those holding this view (like us), they held it at higher yields than these and so far it has not been right. At the risk of being stubborn, lower bond yields simply make it more right than it was. The latest Federal Reserve plan to shift its purchases of bonds to longer maturities (“Twist”) has perversely caused short term rates to drift up somewhat even while the Fed’s prospective buying (and coincident negative economic outlook) has driven long term yields down. In fact government bond markets are increasingly manipulated by governments, and therefore look less appealing places to invest. Even without a view on whether inflation in five years will be sharply higher, lending to anybody for ten years at less than 2% doesn’t seem much more compelling than holding cash. For the taxable investor assuming a 40% tax rate, 2% pre-tax is 1.2% after tax which over ten year  turns $100 into just under $113 (and unless inflation averages no more than 1.2% over the same period guarantees a loss in purchasing power). The economic environment that would make today’s buyer of 2% yielding government bonds happy in ten years’ time is unlikely to be kind to most types of credit risk. High grade corporate bonds linked as they are to government bonds offer only modestly better prospects. So today’s buyer of corporate bonds desires many years of economic misery to contain inflation but not so much so as to damage corporate creditworthiness, a fairly precise forecast that doesn’t leave much room for error in either direction.
Virtually all investors have an allocation to fixed income in one form or another. While bonds have not looked cheap for a long time it does seem that today’s low yields, distorted as they are by government intervention, demand a robust response from investors. Since public policy is to make the goal impossibly narrow, maybe it’s time to take your ball and go home. If an investor shifted $100 out of fixed income and allocated $80 to 0% yielding cash, the remaining $20 invested in risky assets (such as equities) need only grow at 6% p.a. pre-tax to generate the same $113 of ultimate value as in the ten year treasury example above (assuming a 15% tax rate on dividends and capital gains).
To illustrate with some brief Math: since dividend yields are 2%, this only requires 4% of annual growth. 2% dividend yields imply companies are paying out only 2/9ths of profits (as earnings yields are 9%). The remaining 7/9ths that’s retained would need to earn a return on equity (ROE) of only 5% to generate the 4% dividend growth noted above (dividend growth = % of earnings retained X ROE; 7/9ths of 5% is approximately 4%). A 5% ROE is around half the current cost of equity implied by the S&P500’s 9% earnings yield. To summarize without the Math – being more pessimistic than this probably isn’t the winning side of the trade over the long run. In the short run, anything can happen.

The 80/20 Cash/Stock substitute for fixed income doesn’t need to jump very high to clear the performance hurdle that’s been set. It incorporates some attractive upside, in that dividends may grow faster than 4%. And one day in the far distant future, maybe cash will even sport a yield again as it once did. This strategy also provides the flexibility to invest some of the cash at a later date, perhaps when the economic outlook is clearer and when bonds would presumably have to be sold at a loss.
We don’t yet have the requisite Newsweek cover announcing “Why You Should Only Invest in Bonds”, but the Math is starting to look compelling. Alternatives to bonds include MLPs (currently offering around 6% tax deferred yields with a solid history of distribution growth); stocks with long histories of reliable dividends; bank debt, and the cash/equities barbell described above.

The Credit Risk in Bank of America

Many perverse things are happening in financial markets beyond the easily visible carnage in equity markets. Take Bank of America (BAC) for example. Credit insurance for one year through a credit default swap (CDS) costs 4.35% (according to Bloomberg). One year LIBOR is 0.85%. How does Bank of America function in today’s money markets, where presumably nobody will lend to them at anything close to prevailing rates when the cost of insurance is five times as much. Presumably the only inflows they are receiving are those small enough to qualify for FDIC insurance (i.e. under $250K).

 

Author has no position in BAC

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