Yield curve trap

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Feb 5, 2007 10:34 am

As we've already covered, the inverted yield curve shows us that the bond market is betting that rates are headed lower. Not only short rates, but long rates too. Could retirees be making a big mistake by not locking in today's long term rates?


I just read an article that brings this home. If short rates go from 5% to 3%, certainly withing the realm of possiblity, retirees relying on that income would take a 40% income cut. Hmm? That's a chunk of income. That's asset eating lifestyle changin income. So what to do?

Feb 5, 2007 11:25 am

It suggests two simple things to me:

1.  It is important for retirees to be careful about how they arrange their fixed income along the yield curve....to not fall into the trap of having everything short under the presumption that better days/higher rates lie ahead.

2.  It is also advisable, IMHO, for even the most conservative investors to have some equity exposure.  This can come in the form of high quality dividend oriented securities, and provides a means of a.) hedging against uncertainty in future interest rates, and b.) perpetually growing one's capital base.

Feb 5, 2007 12:06 pm

You guys are making a pretty good argument for a VA with a 5-7% annual income benefit...

Feb 5, 2007 12:33 pm

VA's have been good...

Feb 5, 2007 12:55 pm
Indyone:

You guys are making a pretty good argument for a VA with a 5-7% annual income benefit...



true dat homey!

Feb 5, 2007 6:17 pm

I'd like to start by saying thanks for bringing up something other than

VAs, Ed Jones, Indy or Traditional and such.



I've never been a big proponent of bonds even though I've taken graduate

level coursework in the subject. I promise I won't go into the academic

discussion, so suffice it to say a low-tech, plain-vanilla way to proceed is

just a laddered portfolio. I've never had a client express any

dissatisfaction with this strategy. In fact, its been an excellent pre-cursor

to many rewarding client relationships.



Even though its not peeked much interest on this forum, we can't go

through a week without some Private Equity (PE) deal in the headlines. PE

is buying the cheap asset, which is stock, and selling the expensive asset,

which is debt. This IS the smart money, and that is HOW they are playing

it. We, as advisors should take note of this and convey this to our clients.



I would advise the following to an investor seeking income (as opposed to

an investor seeking only bonds): 20% utility stocks, 20% REITS, 20%

emerging market bonds, 20% high dividend stocks and 20% floating rate

bonds.

Feb 5, 2007 9:26 pm
skeedaddy2:


an investor seeking only bonds): 20% utility stocks, 20% REITS, 20%

emerging market bonds, 20% high dividend stocks and 20% floating rate

bonds.





Two points,



1) It's important to be very picky with REITs, alot of the valuations
of big REITs are just silly. REIT preferreds may be a much better value
all-in. IMHO people who buy ICF are going to get slaughterd when the
REIT correction takes place.



2) Floating rate securities is a tricky area since there are a lot of
crap senior loans entering the market. As Seth Klarman noted "The
banks' are senior but everyone is at risk". A senior position in the
capital stack does replace earning power. Some people in the debt
markets seem to forget that.



3) I'm going to say the same thing about EEM debt, I prefer investment
grade preferred stocks to junk debt of any source in the current
enviroment. In a little while the S&P preferred stock ETF will
start trading.



4) As much as TIPS are a chaotic source of income, I think a small allocation to TIPS is good in every portfolio.



5) An ETF like PFM, PID, VIG or SDY that is based on companies with an
history is increasing dividends is a great tool for income investors.
For my more income oriented clients I use a combination of PID/SDY.

Feb 6, 2007 6:59 am
AllREIT:
skeedaddy2:

an investor seeking only bonds): 20% utility stocks,

20% REITS, 20%

emerging market bonds, 20% high dividend stocks and 20% floating rate

bonds.




Two points,



1) It's important to be very picky with REITs, alot of the valuations

of big REITs are just silly. REIT preferreds may be a much better value

all-in. IMHO people who buy ICF are going to get slaughterd when the

REIT correction takes place.



You ought to be picky whenever you invest.



2) Floating rate securities is a tricky area since there are a lot of

crap senior loans entering the market. As Seth Klarman noted "The

banks' are senior but everyone is at risk". A senior position in the

capital stack does replace earning power. Some people in the debt

markets seem to forget that.



You can't overlook the fact that the historical default rate

in senior loans is less than 2%, odds that I'm willing to accept.



3) I'm going to say the same thing about EEM debt, I prefer investment

grade preferred stocks to junk debt of any source in the current

enviroment. In a little while the S&P preferred stock ETF will

start trading.



That's fine. Hey, different opinions are what makes a

market work. You're just missing out on the world's fastest growing

economies and very handsome rewards too.



4) As much as TIPS are a chaotic source of income, I think a small

allocation to TIPS is good in every portfolio.



You'll be taking the opposite side of Bill Gross. My money

is on him.



5) An ETF like PFM, PID, VIG or SDY that is based on companies with an

history is increasing dividends is a great tool for income investors.

For my more income oriented clients I use a combination of PID/SDY.



At least we agree on one point.

Feb 6, 2007 9:56 am
skeedaddy2:


You can't overlook the fact that the historical default rate

in senior loans is less than 2%, odds that I'm willing to accept.






Remember the old saying "Past performance is not necessarily indicative of future results."?

Well I submit this is especially true in the state of the senior loan market.  Ten years ago it was a niche.  Nowadays the volume is huge and everyone on the street has a loan trading desk.  Individual investors are flocking to the funds, as they are desparate for yield, and their advisors are answering the call.  Many of these advisors buying the senior loan funds have never been through a high-yield meltdown, so they don't know better.

It won't end well, IMHO.  HY spreads are the tightest they've been in years.  Now all we need is some sort of "oops" to shake people up!

Feb 6, 2007 10:46 am
joedabrkr:
skeedaddy2:


You can't overlook the fact that the historical default rate

in senior loans is less than 2%, odds that I'm willing to accept.



Remember the old saying "Past performance is not necessarily indicative of future results."?

Well
I submit this is especially true in the state of the senior loan
market.  Ten years ago it was a niche.  Nowadays the volume
is huge and everyone on the street has a loan trading desk.

It's the same as Junk bond's pre 1982. Most junk bonds were "fallen
angels" trading at a deep discount to par vs fresh junk trading at par.
Totally different asset classes. And we all know how the 1980s junk boom ended.



Fitch ratings and other agencies are not amused at the low quality
loans that are comming to market. Covenant lite, and often the result
of dividend recap's and other non-productive uses of borrowed funds.



Something else that people are forgetting is how hard it is to raise money under normal conditions for company's who are already mortgaged-up with senior loans. Trying to flog CCC rated junior debt is no fun in a tight credit market.



Part of the reason senior default's are so low, is that it is so easy
to raise up junior debt at low rates in the current markets. So
obligors just roll over old loans as they come due.



Individual investors are flocking to the funds, as they are
desparate for yield, and their advisors are answering the call. 
Many of these advisors buying the senior loan funds have never been
through a high-yield meltdown, so they don't know better.

It
won't end well, IMHO.  HY spreads are the tightest they've been in
years.  Now all we need is some sort of "oops" to shake people up!





And it's a double witching since spreads will go up as soon as default
losses start rising. So a portfolio of junk bonds will lose money on
the defaulted bonds, and the rest of the portfolio will decline in
price as well.










Feb 6, 2007 11:25 am

It will be interesting to see how "liquid" or deep the market is when all those newby trading desks are trying to sell the same names into it....

Feb 6, 2007 1:57 pm

The highland  floating rate and ING (the old Pilgrim prime rate fund) have been through bad times before. I would rather take the risk of default on these investments than buy a 30 treas. paying 4.92% even if logic says that rates are going down. I will not buy a reit  common stock now, but I will the preferreds. But if rates go lower, the market should go higher. ii hope

Feb 6, 2007 2:08 pm
aldo63:

The highland  floating rate and ING (the old Pilgrim prime rate fund) have been through bad times before. I would rather take the risk of default on these investments than buy a 30 treas. paying 4.92% even if logic says that rates are going down. I will not buy a reit  common stock now, but I will the preferreds. But if rates go lower, the market should go higher. ii hope



Define "bad times"...

Feb 6, 2007 2:23 pm
joedabrkr:
aldo63:

The highland  floating rate and
ING (the old Pilgrim prime rate fund) have been through bad times
before. I would rather take the risk of default on these investments
than buy a 30 treas. paying 4.92% even if logic says that rates are
going down. I will not buy a reit  common stock now, but I will
the preferreds. But if rates go lower, the market should go higher. ii
hope



Define "bad times"...





Hard times. Like when defaults happen, the IPO markets get tight and
credit spreads widen alot. Say 1989-1991. The market for junk loans
isn't all that big, so you have all these funds, invested in all the
same names.



And survival bias causes a real problem since the good credits pay off
their loans quickly, while the bad credits linger and die on you. Given
that defaults tend to start up around T+3, we are about a year or so
away from the first wave of "credit events"



Nows a great time to move up in credit quality.

Feb 6, 2007 3:24 pm
AllREIT:
joedabrkr:
aldo63:

The highland  floating rate and
ING (the old Pilgrim prime rate fund) have been through bad times
before. I would rather take the risk of default on these investments
than buy a 30 treas. paying 4.92% even if logic says that rates are
going down. I will not buy a reit  common stock now, but I will
the preferreds. But if rates go lower, the market should go higher. ii
hope



Define "bad times"...





Hard times. Like when defaults happen, the IPO markets get tight and
credit spreads widen alot. Say 1989-1991. The market for junk loans
isn't all that big, so you have all these funds, invested in all the
same names.



And survival bias causes a real problem since the good credits pay off
their loans quickly, while the bad credits linger and die on you. Given
that defaults tend to start up around T+3, we are about a year or so
away from the first wave of "credit events"



Nows a great time to move up in credit quality.



Not sure I know what you mean by t+3, but agree with your sentiments regarding quality.

The difference between those "bad times" and now is that there is a LOT more players in the market, many with limited experience, and a lot of cash sloshing around seeking incremental returns.  Many of these bonds are bought on leverage aka 'the carry trade', and if things start to go south it could, IMHO, get ugly quickly.

And then you have all the individual investors who purchased these as "CD alternatives", and how they will react when they see values decline on their statements.

Feb 6, 2007 3:45 pm

Not sure I know what you mean by t+3, but agree with your sentiments regarding quality.



I ment that defaults start happening as loans get seasoned, usually they start up around year three.

The
difference between those "bad times" and now is that there is a LOT
more players in the market, many with limited experience, and a lot of
cash sloshing around seeking incremental returns.  Many of these
bonds are bought on leverage aka 'the carry trade', and if things start
to go south it could, IMHO, get ugly quickly.


There is also a huge market for
credit default swaps and all sorts of other untested speculative
instruments. Alot more people are speculating on junk debt than
actually own it.


And then you have all the individual investors who purchased these
as "CD alternatives", and how they will react when they see values
decline on their statements.



Badly, They will react badly.



Alot of people who wouldn't think to have a portfolio that was 25% junk bonds think nothing of having 25% in junk loans.


Feb 6, 2007 3:51 pm

Being a weaner generalist, I like to use some of the brand name strategic income bond funds, like Fidelity Advisor Strategic Income, and other "big" names.


It will be interesting to see how they handle the junk bond portion of the portfolios through active management, or balance that against the international and higher quality shorter duration.


Anyone else using this as part of their strategy - getting nerous, feeling good?


Joe, you are the CFP whiz student now, we are counting on you. Would that be Treasury plus 300 basis points, or something? I forgot a lot of that really important stuff. The Fidelity guys in Boston all wear neckties (even when they come out west) and they seem to be really smart. I throw in a few other geographic regions, neckties plus golf clothes, brand names, ETFs, TIPs, cash, advise client to buy a big home for potential appreciation and tax savings, and pray for the best. But I'm getting nervous again.


Feb 6, 2007 4:54 pm
joedabrkr:
skeedaddy2:

You can't overlook the fact that the

historical default rate

in senior loans is less than 2%, odds that I'm willing to accept.



Remember the old saying "Past performance is not necessarily

indicative of future results."?Well I submit this is especially true in the

state of the senior loan market. Ten years ago it was a niche. Nowadays

the volume is huge and everyone on the street has a loan trading desk.

Individual investors are flocking to the funds, as they are desparate for

yield, and their advisors are answering the call. Many of these advisors

buying the senior loan funds have never been through a high-yield

meltdown, so they don't know better.It won't end well, IMHO. HY spreads

are the tightest they've been in years. Now all we need is some sort of

"oops" to shake people up!





I happen to like the fact that there are more participants in this market.

I'd much rather prefer a more transparent and liquid market to invest in.



Following your point about a melt-down in Sr. FRNs would suggest that

we should stay away from all other asset classes for fear of a melt-down

too, and we all know that's not practical (if we want to stay in this

business). None of these should be positioned as a CD alternative.



Looking at some historical performance (as measured by the CSFB

Leveraged Loan Index), the asset class did well during difficult bond

markets, 1994 & 1999, way better than high yield and govi's. Basically,

you're getting the same return as govi's with 1/3 the volatility.



The question was "what to do?" about a client seeking income and I

offered my two cents. Finding the right mix of returns and volatility for

your client is how we add value to a relationship.



Feb 6, 2007 4:59 pm

I don't use many "strategic income" products because frankly I'm not comfortable with not knowing what is under the hood.

When I can get a 6% current yield and about a 5% expected YTM/ELTR on a plain vanilla "pays cash monthly" GNMA UIT from First Trust, I fail to see the attraction of taking the risk involved in some of these other products.  There is extension risk in the GNMA's, but no credit risk.  If I want to be even a little more conservative we can put some of the $ in 1-2 year CD's or corps.

For funds I use DGCAX and VFSTX, and read the profiles carefully to make sure they are staying investment grade.

I owned a bunch of PHD-a senior loan fund which is managed by Highland Capital.  Many guys believe them to be the best in the business.  I bought a little on the IPO at 20, and loaded up when the IPO ended up being "broken"(like many CEF IPO's) and bought a whole bunch around 16 and 17.  I just got done tossing all of it last month after reading a thread on here where several folks implied that they were using this asset class as a "CD alternative", and talking about how there was really not much risk.  That was enough for me.  I pulled up my cross post, found that I had gains of around 20% mostly in tax sheltered accounts, and punted all of it within a week or so.  That included some that I owned personally at a nice profit.

I'll miss the 9% plus dividend, but in the end this is a specialized and leveraged junk bond fund in a market niche that has exploded in volume in the last 5-10 years.  I'll sleep just fine at night knowing I took my profits off the table.  When the defaults start up and the valuations drop because everyone wants out, then I'll come back.

I feel much the same about REITS right now.

planrcoach:

Being a weaner generalist, I like to use some of the brand name strategic income bond funds, like Fidelity Advisor Strategic Income, and other "big" names.


It will be interesting to see how they handle the junk bond portion of the portfolios through active management, or balance that against the international and higher quality shorter duration.


Anyone else using this as part of their strategy - getting nerous, feeling good?


Joe, you are the CFP whiz student now, we are counting on you. Would that be Treasury plus 300 basis points, or something? I forgot a lot of that really important stuff. The Fidelity guys in Boston all wear neckties (even when they come out west) and they seem to be really smart. I throw in a few other geographic regions, neckties plus golf clothes, brand names, ETFs, TIPs, cash, advise client to buy a big home for potential appreciation and tax savings, and pray for the best. But I'm getting nervous again.


Feb 6, 2007 5:25 pm

i am more concerned about the residential real estate market than floating rate funds. I do not use the leveraged floating rate products. The senior bank loan market is more liquid than the longer term high yield market and certainly more than real estate which I believe the defaults are coming. There is much more money  in loans to higher credit risk customers, small business,developers,ect than senior floating rate funds. There is a market for floating rate loans,where real bank loans to a small busines have no liquidity. If you put a credit rating on most small business it would be in the junk range. Many banks will fail if this scenerio happens. So what you are saying is that we are going to have a 1929 type collapse? If that is the case, i believe in the put you money in a shoebox theory.


We also had this discussion on this board early last year and NOTHING HAPPEND except a 7.5% return on the highland floating rate fund.