AAII
submits:
The Federal Reserve continues to be the enemy of savers. The
minutes of the September Federal Open Market Committee ((FOMC))
meeting, released earlier this week, signaled the possibility of
new actions to bring long-term interest rates down further.
Specifically, several committee members stated that if the pace of
the economic recovery does not strengthen or if inflation does not
intensify, "they would consider it appropriate to take action
soon."
What could this action be? Most likely, it would involve the Fed
purchasing more Treasury securities. Since bond yields are
inversely related to bond prices, more demand for Treasuries should
effectively drive down yields. The FOMC also considered providing
some type of target rate for either inflation or nominal GDP. (A
nominal rate includes the impact of inflation. Conversely, a real
rate is the nominal rate less the rate of inflation.)
Any such action would be referred to as a second round of
quantitative easing, or as folks in the financial industry prefer
to say, "QE2." It is not definitively known if the Fed will act,
though many economists think an announcement could be made on
November 3, at the end of a two-day FOMC meeting. As stated below,
in The Week Ahead section, eight Fed officials will make public
speeches next week, so we could get some additional hints.
None of this is particularly helpful if you rely on your portfolio
for income. Rather than fretting, however, focus on navigating your
portfolio through the current interest rate environment. Barring an
unexpected improvement in the economic data, the Fed seems likely
to keep interest rates low for an extended period of time. That
said, interest rates will eventually rise as inflation intensifies.
(Ibbotson calculates that U.S. inflation has averaged 3% per year
since 1926.)
Since the future is never what we expect it to be, the best
portfolio moves are those based on what we know about individual
asset classes. Here are some things to consider.
Bonds
- Bonds play three important roles in a portfolio. First, they
provide a fixed stream of income. Second, bonds offer return of
capital when held until maturity. (Corporate bonds are not
completely without risk, so be sure to monitor the fiscal health of
the issuer.) Finally, bonds have historically had low correlations
with stocks. (When stock prices zig, bond prices often zag.) Thus,
even in the current low-yield environment, bonds should not be
ignored.
The obvious problem with bonds right now is that you can be stuck
with securities that pay a low rate of interest. If inflation
rises, the low yield could cause you to lose money on an
inflation-adjusted basis. There is also the problem of reinvestment
risk, meaning current bonds are paying a lower rate of interest
than maturing bonds are. This happens when a higher-yielding bond
matures in a lower interest rate environment. You are effectively
being penalized for maintaining your portfolio allocation to bonds.
There are strategies that can be used without exposing yourself to
significantly more credit risk (the risk of a bond issuer
defaulting). The first is to ladder your bonds. This is
financial-speak for buying bonds of varying maturities. Since you
don't know when interest rates will actually rise, you take the
timing element out of your investing decisions. (This is akin to
dollar cost averaging with stocks.) The second is to invest in
overseas bonds. An international bond exchange-traded fund ((
ETF
)) or a mutual fund can help facilitate this. Though there is
currency risk - the chance that the greenback will appreciate
against a foreign currency, thereby decreasing the dollar value of
international bonds and their interest payments - you'll lessen
your direct exposure to U.S. interest rates. Finally, you could buy
Treasury Inflation-Protected Securities ((
TIPS
)) whose principal and interest payments adjust with inflation.
REITs
- Most real estate investment trusts manage property, such as
office buildings and apartments. Some, however, do own mortgages
and mortgage-backed securities. REITs trade with higher yields
since they must distribute at least 90% of their income to
shareholders annually. The negatives are higher correlations with
stocks and a dependency on the health of the real estate market.
Taxes can be more complicated too, since distributions are
allocated to ordinary income, capital gains and return of capital.
MLPs
- Master limited partnerships are most often found in the energy
sector, and many operate pipelines. MLPs have higher yields because
pretax income is passed along to the unitholders. Though they can
provide a higher stream of income than stocks and many bonds, taxes
are more complicated. Furthermore, MLPs are problematic when held
in an IRA if annual distributions top $1,000, and debtholders can
force unitholders to pay back distributions. (MLPs are traded as
units instead of shares and pay distributions instead of
dividends.)
Preferred Stock
- This is a hybrid security that also provides higher yields. The
advantages of preferred stock are that preferred shareholders are
entitled to receive dividends before common shareholders. Plus,
dividends are cumulative: If a dividend payment is missed,
preferred shareholders must be paid all past due dividend payments
before the common stock dividend can be reinstated. The downsides
are that voting rights are limited, bondholders have a priority
claim to all assets in the event of bankruptcy, and prices are
sensitive to interest rate movements.
Keep in mind that while REITs, MLPs and preferred stock can
supplement portfolio income, they do not provide the portfolio
allocation benefits that bonds do. In addition, REITs, MLPs and
preferred stocks must be sold to get your investment dollars back,
whereas bonds pay a set amount of money (e.g., $1,000 per bond) at
maturity, even if market conditions are worse than when you
purchased the security.
Thus your goal should be to maintain a proper allocation to bonds
and use other asset classes to increase your portfolio income,
instead of simply avoiding bonds because of the ongoing uncertainty
about future interest rates.
THE WEEK AHEAD
Approximately 100 members of the S&P 500 are scheduled to
report earnings next week. Included in this group are several Dow
components. Bank of America (
BAC
), Coca-Cola Company (
KO
) and Johnson & Johnson (
JNJ
) on will release third-quarter results on Tuesday. Boeing Company
(
BA
) and United Technologies (
UTX
) will report on Wednesday. American Express Company (
AXP
), Caterpillar (
CAT
) and The Traveler's Companies (
TRV
) are scheduled for Thursday. Verizon (
VZ
) will report on Friday. Other notable members of the S&P 500
scheduled to report are Apple (
AAPL
) and Goldman Sachs (
GS
). AAPL will release results on Monday and GS will announce profits
on Tuesday. Economic data will likely to take a back seat to
earnings news, but there will be some reports to pay attention to.
September industrial production and capacity utilization and the
National Association of Home Builders ((NAHB)) October housing
index will be released on Monday. Tuesday features September
housing starts. The Federal Reserve's Beige Book will be published
on Wednesday. The September Philadelphia Federal Reserve's
manufacturing survey and the Conference Board's September Leading
Indicators Index will be published on Thursday. Several Fed
officials will be hitting the speaking circuit next week. All of
their comments will be scrutinized for any hints as to whether the
Fed will announce QE2 at the November meeting. Atlanta Federal
Reserve Bank President Dennis Lockhart will talk on Monday.
Minnesota Federal Reserve Bank President Narayana Kocherlakota,
Chicago Federal Reserve Bank President Charles Evans and Dallas
Federal Reserve Bank President Richard Fisher will make public
appearances on Tuesday. Richmond Federal Reserve Bank President
Jeffrey Lacker and Philadelphia Federal Reserve Bank President
Charles Plosser are scheduled for Wednesday. St. Louis Federal
Reserve Bank President James Bullard and Kansas City Federal
Reserve Bank President Thomas Hoenig will speak publicly on
Thursday.
See also
Cramer's Mad Money - Is There a Reason to Have
Faith in Mannkind? (10/14/10)
on seekingalpha.com