The markets have suddenly become seriously concerned about a second recession following resolution of the debt ceiling debate in Congress. While the Republicans won their point that taxes should not be increased in a weak economy, we lost sight of the fact that you should also not cut back on spending while the economy is still struggling. Debt ceiling compromise on spending cuts was much maligned because so little was actually cut out of current or next year’s budget. This actually makes sense given the weak recovery, but that reality seems to have been lost on the markets. As one observer noted, the debt ceiling compromise focused on how to cut back when what is needed is a focus on how to stimulate growth. Its times like these you wish our government provided for a no confidence vote, like they have in Canada or the UK, that would precipitate an immediate election rather than one in 16 months. The financial correction taking place as this is being written bears out the worst fears about Washington’s ability to fix a problem which was as much of their own making as of the Wall Street players who got most of the blame.
Based on the reaction to the debt ceiling compromise, it looks like low interest rates are here to stay for a while longer. I have been predicting that rates would rise and have encouraged investors to seek protection by buying adjustable rate debt and closed end funds investing in these securities. One would think that such a missed call would result in losses or at a minimum lost opportunity, but such has not been the case. In fact, these adjustable rate issues provide a higher yield to call than fixed rate issues. This is because most of those fixed rate issues with a 6% or higher coupon rate are likely to be refinanced. This means they are trading on a yield to call basis with returns measured in basis points rather than percentages. It also means they are trading above the par value at which they would be redeemed. Those who bought the high coupon fixed rate trust preferreds issued by the banks in 2008 to beef up their capital base thought they were safe from call for five years, but leave it to Congress and the Dodd-Franks Financial Act to undo these securities. That act said these preferreds could no longer be considered part of the tier one capital base of the banks thereby allowing an early call under a clause which allows this for such statutory changes. Think of it as Chris Dodd’s going away present to his banker friends.
Special Offer: Safety In High-Yield. Three of Richard Lehmann’s fixed-income portfolios yield more than 7.1%. Click here for to gain access to his portfolios in Forbes/Lehmann Income Securities Investor.
Adjustable rate securities normally trade at lower yields than comparable fixed rate securities due to the possibility of a rising yield. They pay monthly or quarterly based on a Treasury bond index, LIBOR, or the consumer price index percentage change plus a fixed interest amount. The rate adjustment is designed to keep the securities market value stable at around the par or face value, but this is not what has been happening. They will normally have a floor interest rate below which the payout rate will not go. The most common floor rate is 4%, a rate which was considered meager at the time these securities were issued, but which is close to current yields. In addition, many are selling at several points below par value, probably because they are perceived as an inflation hedge instrument in a period when inflation fears are falling. This means that, you can buy an adjustable rate security paying a current yield at below par value. Hence, the inflation protection is free. While that may not seem like much today given that the adjusted rate is significantly below the 4% floor, inflation fears don’t need much to be rekindled and then you needn’t worry about repositioning your portfolio or fear suffering from being in fixed rate instruments. Go to our website to see the 14 adjustable rate issues we continue to recommend.
I predicted interest rates rising in 2009 on the conviction that government and the Fed wanted inflation because it could remedy so many of our current economic woes. They failed in achieving this because our economic situation was even worse than expected so their inflationary policies were not enough, just as their stimulus policies were not enough. Anyone who bought an ETF or ETN to protect against an interest rate rise should sell that position since a significant rise in rates anytime soon appears unlikely.
My comment last month about preferring adjustable rate issues tied to the CPI over those tied to a treasury or LIBOR index lead many subscribers to inquiry which specific issues are tied to the CPI. Unfortunately, I failed to notice that we had only two recommended issues which are tied to the CPI; the Prudential Financial (PFK) and the SLM Corp issue (OSM) which we recommended in April. Note that some of the closed end funds investing in adjustables have such securities in their portfolios, but the magnitude of their holdings is not known.
The investment outlook picture for the remainder of the year is not promising unless you are in income securities. The economy looks weak and loan demand is low, so interest rates should remain low. Those who hold securities that still pay 5% or more in dividend yields should hold on unless they are selling at premium prices and have a yield to call of only a percent or less. If you hold such securities which are vulnerable to a call and would give you a nice long term capital gain, they should be sell candidates. I believe the current mispricing of adjustable rate securities will correct itself as investors recognize that higher coupon paper will be called away. Blue chip stocks that pay 4% or more in dividends are also still on my buy list. And as for gold, a position of 10% of your portfolio via an Exchange Traded Fund (GLD or IAU) is my minimum. Given the current market turmoil, however, wait to see that the market has turned around before taking any buying action. Meanwhile, raise some cash.