The outlook for traditional bonds and bond funds doesn’t look great with historically low yields today, and perhaps even lower yields and values on the horizon.
“Our concern today is that people are putting a lot of money into traditional bond funds, seeing the income that these bond funds produce,” says Jim Bernard, CFA, senior vice president and director of fixed income portfolio management, as well as an investment advisor representative at Ancora Advisors LLC.
However, that income is already falling and Bernard says it is going to continue to drop significantly.
“On top of that, the net asset values of these funds will be falling as the bonds they hold move closer to maturity because values today, in many cases, are significantly higher than the face value at which the bonds will pay off,” he says.
Smart Business spoke with Bernard about how the bond market works and what that means for investors’ portfolios.
How does the traditional bond market work?
Bonds are continuously traded based on two things: the risk of the investment and the current interest rate environment. Currently, the likelihood of credit defaults is low for both corporate and government bonds. However, if a company has a history of losing money, you will want to pay a lower price for that bond or demand a higher interest rate in order to offset the risk of not getting your money back at maturity.
Interest rates and bond prices have an inverse relationship — as interest rates go down, bond prices go up. If you own a bond that pays a stated interest rate of 5 percent, due in three years, it would currently be worth more than face value to an investor because bonds maturing in three years are currently only paying 2 percent.
What do low interest rates and falling bond yields mean for investors?
Interest rates are low and have been for almost five years. They will likely stay this way for another two to five years. So the challenge is deciding whether investors should buy bonds that pay low rates of interest or put money in other places — the stock market, commodities, gold, real estate, etc.
If you bought a 15-year bond 10 years ago when interest rates were 5 percent or more, you might be happy. Unfortunately, most people tend to invest in bonds maturing within five years or sooner, and that means their bond holdings are at historically low yields.
What is the difference between owning an individual bond and a bond fund?
With individual bonds, you get the face value of your bonds back at the maturity date or call date, barring a default. In a bond fund, because it is perpetual, you never know what the future value will be.
Most investment advisers would prefer people invest in individual bonds if they have enough money to adequately diversify simply because of the added comfort of knowing what your bonds will be worth at maturity.
If you do not have enough capital to adequately diversify, or are in an instrument such as a 401(k), where individual bonds are unavailable, you may have to invest in bond funds if you want fixed-income exposure. You then must decide whether you are more concerned about the value of your fund or the income it produces.
What can we expect from bond funds in the future, and what should investors in bond funds do now?
Most individuals invest in bond funds in order to receive income, but that income has dropped dramatically as interest rates have fallen. For instance, one intermediate-term corporate bond fund has paid an average dividend yield of 5.4 percent over the past 12 months, but the current yield has already dropped to 3.3 percent. With five-year government bonds currently yielding 0.63 percent, is it not likely that the current 3.3 percent yield will be maintained.
The second reason an investor would buy a bond fund is for the net asset value of the fund. The net asset value of a bond fund typically only goes up when interest rates go down, but can interest rates go much lower, and therefore can bond prices go much higher? And even if interest rates stay flat, the net asset value will decrease as bonds within the bond fund get closer to maturity since the majority of bond prices are currently above face value.
So in general, concerning traditional bonds and bond funds, this is not a great time to be in either. If you have owned bonds or a bond fund for many years, you may be comfortable. However, for new money or money from maturing or called bonds, there are other, more attractive sectors with bond-like returns that are not as tied to interest rates. These include:
• Master limited partnerships, which pay a rate of interest through the infrastructure of the U.S. energy system, pipelines, etc.
• Certain real estate investment trusts, where income is derived from real estate projects.
• Certain sovereign bonds, which are non-U.S. government bonds and offer a way to diversify from the U.S. dollar.
• Merger arbitrage funds, which have bond return characteristics but are invested in equities.
If your bonds are still paying a good rate of interest, there is no need to be too concerned about selling as long as you are confident you are going to get your money back at maturity. However, right now may not be a good time to allocate new investments to the bond market.
Jim Bernard, CFA, is senior vice president and director of fixed income portfolio management as well as an investment advisor representative at Ancora Advisors LLC, an SEC-registered investment adviser. He is also a registered representative and a registered principal at Ancora Securities, Inc., member FINRA/SIPC. Reach him at (216) 593-5063 or firstname.lastname@example.org.
Arbitrage is a trading technique that has been around for decades, but it’s not one that most investors have heard of.
However, in today’s economy, it can be a smart investment, says Brian Hopkins, portfolio manager at Ancora Advisors, LLC.
“Warren Buffett employed this strategy for decades with his short-term bond money, until Berkshire got so big that he couldn’t do it anymore,” says Hopkins. “It has been a smart money strategy for decades.”
Smart Business spoke with Hopkins about arbitrage and how it can benefit an investor’s portfolio.
What is arbitrage?
Arbitrage can take two forms. One is purchasing a security with a known value in the future trading at a discount to that value after adjusting for the risk free rate. Another is when two securities with virtually identical characteristics trade at different prices. An arbitrageur can purchase the cheaper security and sell short the more expensive security and wait for the two securities to reflect their intrinsic value.
One example of this is merger arbitrage, a strategy employed when a company is being purchased by another company. Typically, there is a six-month window between when a merger is announced and when the deal finally closes. Often, during that six-month period, the stock of the company that is the target of the takeover will trade at a discount to final value because the large mutual funds are not concerned about making that incremental couple percent and decide to sell. As a result of this selling, the market price of the target company may be less than the final transaction price. At this point, an arbitrageur can step in and buy the shares of the company being acquired. The bet is that the deal will close and the spread between the market price and the takeover price will close to zero.
Another arbitrage example is when you take advantage of the mispricing of different securities that relate closely to one another. For instance, a number of companies have two classes of common stock. One will be voting stock and one is nonvoting stock and they both trade on an exchange. They have the same economic rights in terms of dividends, cash flows, proceeds in a sale etc. so they are identical except for the voting rights. Typically the share class with the higher voting rights trades at a steady, predictable premium to the nonvoting class.
For a variety of reasons, there can be times where temporarily the steady, predictable spread widens or maybe even inverts. In that scenario, the arbitrageur buys the less expensive stock and shorts the more expensive stock. An arbitrageur would then wait for the two classes of shares to come back to the normal premium/spread relationship. This strategy has limited risk because you are only betting that the historical relationship between the two share classes will restore itself.
Is this strategy one that investors can pursue on their own?
I would advise against it. An arbitrageur will run several screens to identify opportunities, using technology that feeds in pricing data for different types of securities and the relationships between them. There is quite a bit of manpower that goes into identifying and researching those opportunities and managing overall portfolio risk.
Why is now a good time to consider this strategy?
Historically, the risk of arbitrage strategies as measured by standard deviation has been in line with the risk of the bond markets. Our feeling is that the bond market right now does not offer investors much in the way of return on capital. Fixed income investors are losing purchasing power because the yields on many bonds today are less than the rate of inflation. This is where an arbitrage strategy can come in as a complement to fixed income only portfolios.
Arbitrage has historically outperformed bonds and inflation, and we think will do so again in the future. In the current environment, we believe it represents a good way for conservative investors to diversify their sources of return away from fixed income only.
In terms of the environment for public company merger activity, there is a significant amount of cash sitting on the balance sheets of corporations, and we think that cash may be deployed in part in mergers and acquisitions. This creates a good environment for arbitrageurs because the more mergers the higher the spreads and therefore the rate of return. More deal supply in the market widens spreads and adds upside to the strategy.
What is the risk profile of this strategy?
There is some risk, but the risks of the stock market are much higher. The strategy has only been down twice in the past 22 years. Both occurrences happened in the worst years of the recent bear markets. In 2002, this strategy as measured by the HFRI Merger Arbitrage Index was down 1 percent in a horrible year for the stock market. In 2008, one of the worst years for the market since the Great Depression, the strategy was down 3 percent, giving you a reasonable idea of what can happen in the most difficult of potential environments. Following each of those down years, the strategy bounced back and returned in the double digits the following year, leaving merger arbitrage investors up over the two-year period. The strategy has had numerous years of double-digits returns since the early ’90s, typically in years when merger activity was high.
What role should this strategy play in an investor’s portfolio?
It should be a portion of the portfolio, and investors should view it as an allocation to their fixed income portfolio.
An attractive element is that the correlation between this strategy and fixed income is very low. As a result, as you add a merger arbitrage strategy, the volatility of your fixed income portfolio should decrease.
Brian Hopkins is a portfolio manager at Ancora Advisors, LLC (an SEC Registered Investment Advisor). Reach him at (216) 825-4000 or email@example.com.
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The investment market has been rocky the past few years, and there is no indication that volatility is going to change any time soon.
But current market conditions make it an excellent time to invest in dividend-paying stocks, says Sonia Mintun, CFA, vice president with Ancora Advisors LLC.
“Given the historically low bond yield environment, dividend-paying stocks are an attractive alternative,” says Mintun. “Right now, you can assemble a portfolio of quality stocks with a yield of 3 to 3.5 percent, in comparison to the 10-year Treasury yield of approximately 2 percent. Dividend-paying stocks also offer downside protection, providing a cushion during negative equity markets, while also allowing for the capture of upside potential.”
Smart Business spoke with Mintun about why dividend-paying stocks are a smart investment in today’s economy.
Why does dividend-oriented investing make sense in today’s markets?
There are several reasons: Dividend-paying stocks are less volatile than non-payers and they have been proven to have a lower standard deviation, which is a measure of risk. Dividends have accounted for 40 percent of total returns in the market since 1940, and dividend-paying stocks have outperformed non-dividend-paying stocks over the last 80 years. These stocks tend to be relatively stable over time because dividends are a component of earnings that are less subject to speculation. In addition, dividends are sticky, and tend not to fall, as companies are reluctant to cut them. Dividends allow investors to collect some income while they’re waiting for the fundamentals of the company to improve.
Furthermore, payout ratios are hovering at extremely low levels historically. They tend to revert to the mean over periods of two to three years. The current payout ratio is 30 percent, compared to a historical rate of 52 percent. With increased confidence and economic stabilization, we will likely see deployment of large cash balances on companies’ balance sheets toward higher payouts.
Dividend yields are also below long-term averages of 2.8 percent. Currently, yields are about 2 percent, despite cash balances being at record highs. Moreover, earnings are recovering from the financial crisis and balance sheets are healthy, so there is good potential over the next year or two that yields will rise due to increased payout ratios.
Last, given today’s bond yields, the S&P earnings yield — which is the inverse of the price/earnings ratio — is pretty attractive relative to the 10-year Treasury on a historical basis.
How does inflation impact dividend-paying stocks?
Historically, dividends have grown faster than the rate of inflation in the U.S. With 3 percent inflation now, short-term, high-quality, fixed-income instruments are losing purchasing power. You can get a 3 or 3.5 percent dividend yield on a diversified portfolio of good quality stocks, and have potential for income growth relative to the fixed coupon on bonds.
The average dividend income from a portfolio of S&P indexed stocks has grown at a rate of 5 percent per year since inception in 1957, which is one full percentage point over the rate of inflation in the same time period. As a result, dividend stocks offer both the potential for capital appreciation and income growth. Dividends increased more than 10 percent in 2011, on top of a 10 percent gain in 2010. Also, dividend-paying stocks have outperformed more often in higher inflationary times.
What vehicles can be used to implement a dividend-paying strategy?
Investors can buy individual equities in portfolios that are sizable enough to diversify the risk of one particular issue or sector. While dividend-paying stocks tend to be less volatile, it’s prudent to make sure your portfolio is not too concentrated in one sector or company.
Investors can also buy exchange traded funds, or ETFs, that concentrate on dividend-paying stocks. ETFs are a cost-effective way to invest in dividend payers while achieving diversification in smaller accounts. There are also mutual funds that focus on dividend-paying companies. These typically have higher expense ratios than exchange traded funds, but the fund manager can trade them more tactically than ETFs, which are passively managed and based on an index.
Are all dividend-paying stocks the same?
All dividend-paying stocks are not the same. It’s very important to do your homework on the company when you are buying individual stocks. Higher yield stocks are associated with better subsequent performance, but only to a degree. Those in the 3 to 6 percent dividend yield bucket have outperformed their peers, both those with higher dividend yields and those with lower yields.
Stocks with yields in the 6 to 9 percent range and above tend to have a higher standard deviation, or risk. Sometimes investors fall into the yield trap, buying troubled companies that cannot sustain high payouts, leading to cuts in their dividends.
Investors should seek stocks in which the dividend can be sustained, potentially evidenced by a low payout ratio and ample net cash or share buybacks. Look for companies that have consistent cash flow, a healthy balance sheet for their industry and that increase their dividends consistently.
Given today’s historically low bond yields, the potential for inflation down the road, as well as the other reasons I detailed, investing in dividend-paying stocks makes sense. With the expectation that volatility is going to continue due to our upcoming election and events in Europe, investing in less volatile stocks paying dividends is a sound strategy. Furthermore, based on price/earnings ratios and the potential for improving earnings, the disparity between the earnings yield on the S&P relative to 10-year Treasury bonds make dividend stocks an attractive investment.
Bonds have historically been an investment of choice for those looking to diversify their portfolios. Today’s market is no different, but the challenge comes in determining what types of bonds to invest in and the length of time to invest, says Jim Bernard, CFA, senior vice president and director of fixed income portfolio management at Ancora Advisors LLC.
“A prudent move right now in our opinion is to focus on bonds maturing within a three- to seven-year time period,” says Bernard. “Interest rates are very low right now, so it may be tempting to go out to longer dated bonds to get yield. But most investors should be very careful about locking their money up for too long a time. If interest rates increase, the value of existing long dated bonds will likely decrease materially in value. It would then be a long time until maturity before investors get their money back at par value.”
Smart Business spoke with Bernard about the value in U.S. fixed incomes markets and the primary risks faced by investors.
Can you put today’s interest rate environment into historical perspective?
Interest rates have been historically low for three years, and that low interest rate environment is probably going to last another three years, possibly longer. If you keep money in short-term CDs, you will get what you are getting today, which is close to nothing.
Interest rates will begin to increase when the economy and/or market improve. Or, if those things don’t occur, but commodity prices or inflation spiral up, then interest rates will also go up. However, we don’t see a materially better economy for the next few years, and although there may be slight job growth, we think the job market will remain very difficult.
What are the primary risks fixed income investors face today?
First, how can you get any legitimate return on your money without buying long-term bonds or bonds of questionable quality? If you buy a low-rated bond, the probability of getting your all money back at maturity declines.
To get a decent yield, you have to go to long maturity bonds that are going to be due in 15 to 30 years. The risk is that if interest rates were to go up materially in the future, then the value of your bond declines materially.
For instance, if today, you buy a good, AA 15-year corporate bond that yields 4.5 percent, that is great for today. But if in four years interest rates go up and an 11-year bond is trading at a yield of 8.5 percent, the face value of your bond would go down to about 65 cents on the dollar to be yield competitive in the higher interest rate environment.
At that point, you have a decision to make. You are earning 4.5 percent, but you could buy a new bond to earn 8.5 percent. However, the only way to do that is to sell your bond at 65 cents on the dollar. Do you want to take a loss to get more income, or are you going to continue earning 4.5 percent while others earn 8 percent? That’s the dilemma.
That’s why three- to seven-year bonds may be the best move today. If you construct a portfolio of these bonds, for an average maturity of five years, interest rates may go up in three or four years. In that instance, you may not be happy in the short term, but you’re going to have access to your money at face value in the next one to three years, which is better than 10. The price of those bonds will go down but they will mature at face value, and you will know what the future value is and know when that is coming back to you.
How do you view the current municipal bond market?
We like municipal bonds and think they are a good value, but people have to be very careful of what they buy.
We recommend bigger rather than smaller issuers in this uncertain market. There may be municipal defaults on the smaller end of the spectrum over the next few years, as opposed to states and larger issuers.
If a $15 million sewer district bond were to fail, the state of Ohio would survive, even if bondholders didn’t get back all of their money. However, if a multibillion dollar issuer were to fail and not pay back bondholders 100 cents on the dollar, that would have huge ramifications. Issuers with significant size may be too big to fail, but every municipality may not be bailed out.
Are non-U.S. dollar denominated sovereign bonds a good investment?
U.S. currency has been weak against other currencies over the last decade or so. Our view is that until we adequately address our fiscal problems here in the U.S., the dollar will continue to do worse than currencies of countries that are more fiscally disciplined.
We don’t know what the ultimate outcome is going to be with the euro, but we are very concerned. The yen is also uncertain. But we have identified five to seven currencies that we believe are better fiscally positioned and have been more responsible from a budget perspective. We would rather own their government debt than ours because we believe their currency will do better than ours.
We recommend buying three- to seven-year non-euro zone bonds in countries with solid economic positioning and finances.
What are the keys to being an effective long-term fixed income investor?
You have to understand the structure of the bonds you are looking to buy. Is this a bond in which you have a high degree of confidence that you will ultimately get all of your money back? With stocks, you want growth and higher earnings, but with bonds, you care a lot about the issuer’s balance sheet and less about their income statement, because the balance sheet will ultimately determine whether you are going to get your money back.
Jim Bernard, CFA, is senior vice president and director of fixed income portfolio management as well as an investment advisor representative of Ancora Advisors LLC, (an SEC registered investmentadvisor). In addition, he is also a registered representative and a registered principal of Ancora Securities, Inc. (Member FINRA/SIPC). Feel free to contact him at firstname.lastname@example.org or (216) 593-5063.