As we close in on the mid-point of 2014, I am reminded of the panic that was just setting in with respect to interest rate-sensitive ETFs this time last year.
In May of 2013, the CBOE 10 Year Treasury Note Yield (TNX) hit a low of 1.65% and subsequently catapulted to over 2.4% by the end of June. That is a 50% jump in just two short months as a result of tapering rhetoric by then Federal Reserve Chairman Ben Bernanke.
Initially the thought of removing the Fed’s artificial stimulus was abhorred by income investors as the beginning of the end for asset classes such as bonds, REITs, preferred stocks, and utilities. The combination of sharply rising yields along with a bullish equity market was considered to be the perfect recipe for the “Great Rotation” from stodgy bonds to high flying stocks.
In fact, I distinctly remember clients calling me in the third quarter to 2013 to sell all of their interest rate-sensitive holdings. No one wanted anything to do with fixed-income or anything that was tied to a yield other than dividend paying equities.
Of course, investor psychology being what it is, that ended up marking a high in yields and subsequently an excellent time to enter holdings such as the iShares Investment Grade Corporate Bond Fund (LQD), Vanguard REIT ETF (VNQ), or iShares U.S. Preferred Stock ETF (PFF).
At the time those positions looked absolutely foolish in the face of investor sentiment so firmly rooted in the notion that bond yields have nowhere to go but up. However, when so many people are piled on one side of the ship, the smart money is already heading in the other direction to tip the equilibrium back to an even keel.
Flash forward a year later and we are at a completely different phase of the risk spectrum for income investors. The mood has shifted to chasing performance in these asset classes at what may be an inopportune moment to commit new capital at stretched valuations.
The historically low interest rate environment is also creating anxiety to chase yield in areas that conservative investors would normally forgo because of higher credit or structural risk.
Everyone has taken notice of the run in REITs, closed-end funds, utilities, and preferred stocks from those oversold levels and wants a piece of the action before the music stops. On a year-to-date basis, the majority of these asset classes are beating a traditional equity-income benchmark such as the iShares Select Dividend ETF (DVY). In addition, they all have higher yields than the measly 3% dividend stream you receive from DVY.
While it would seem to be a prescient move to supplement your equity income portfolio with alternative asset classes, picking an appropriate entry point is just as important. In my opinion, investors that are looking to increase their exposure to these areas should do so on a modest pullback to increase their odds of a successful long-term trade.
While this may take a dose of patience and discipline, you will likely be more richly rewarded than just plunging large amounts of capital in these income producing areas near all-time highs.
There will undoubtedly be additional bouts of volatility in interest rates this year as the Fed continues to reduce their monthly purchases of treasury and mortgage backed securities. In addition, there is always the potential for another scare in interest rate-sensitive holdings that will lead to another wave of selling pressure. Depending on your risk tolerance, you can use those opportunities to add to core holdings or keep tight stop losses in place to exit historically volatile areas.
Keeping a balanced portfolio and being mindful of the run we have had so far in 2014 will go a long way to ensuring your perspective is in line with your risk appetite.