Looking for Yield in All the Wrong Places
by David Anderson
The tech bubble of 2000 and the credit bubble of 2008 were direct results of the misallocation of capital during an extended period of abnornally low, central bank-sponsored interest rates.
In short, investors couldn’t afford to “fight the Fed.”
Today, savers, retirement plan trustees and endowment-fund sponsors are again looking for places to recoup income they lost as short-term interest rates have again been pushed to near-zero levels. The Fed’s interest-rate policy has helped banks repair their capital condition and has allowed mortgage holders to lock in attractive long-term refinancing, but it has also cost savers and investors about $350 billion of income per year. Since April 2009, a net of more than $1 trillion has been withdrawn from money market mutual funds, while $450 billion has been shifted into bond mutual funds and probably at least that much has moved into longer-term certificates of deposit, annuities and individual fixed income instruments.
Meanwhile, domestic equity funds have experienced net withdrawals of $42 billion. As a group, consumers are increasing their savings rate (currently about 6 percent), as they try to make sense of very difficult economic conditions (particularly related to jobs and housing. In addition, baby boomers are entering or approaching their retirement years with concerns that their investments may not support their lifestyle (and their existing debt-service obligations) without heavy use of fixed-income investments.
Investors and retirees have been aggressively shifting into bond mutual funds and exchange-traded fixed-income investments for nearly two years. And, we often say that if everyone is doing the same thing, you need to be very careful about following their lead. Some closed-end bond funds are financially leveraged in an effort to enhance yield and attract investors. When interest rates change direction, the reverse effects of leverage will be quite devastating.
Another Strategy
We suggest avoiding ETFs and closed-end bond funds that employ leverage. Additionally, the relative spreads on high yield bond funds (a.k.a. “junk” bond funds) have fallen to fairly low levels that do not reflect rational default-risk premiums. Finally, annuities are a devious and expensive option that typically only favors the sales representative.
Various types of look-alike equity investments such as master limited partnerships, real estate investment trusts and Canadian royalty trusts provide greater short-term income payouts, but they use essentially all of their cash flow that exceeds earnings to attract investments, and then go to the capital markets to finance maintenance and expansion needs. For example, one of the most popular MLPs currently has a 6.3 percent yield because its annual payout is $4.36/share on a $68.80 price. But the partnership’s latest 12-month earnings were only $1.51/share! Similarly, one of the better financed REITs has a payout, at $1.70/share, that is less than its cash flow/share of $2.43, but substantially greater than its latest 12-month earnings of $0.43/share. Most of these types of hybrid securities are dependent on a continued ability to finance payouts with new borrowings and/or dilutive secondary offerings.
Instead of “gimmick securities,” we favor many of the well-financed utility and telecom stocks, which in the aggregate offer yields nearly 2 percent above the 10-year Treasury rate (or 4.5 percent, vs. 2.7 percent). Some current examples include: AT&T, Duke Energy, Empire District Electric, Exelon, NiSource, Progress Energy and Verizon Communication, all of which now yield more than 5 percent. Some non-utility and non-telecom stocks that offer fairly generous yields of 3–4 percent may eventually be considered as “growth bonds” (or stocks that grow their dividends). In this group investors might consider H&R Block, Bristol Myers, Conoco, DuPont, Intel, Kimberly Clark, Kraft, Leggett & Platt, Paychex, and Spectra Energy.
Currently, the earnings yield for the S&P 500 is above 8 percent, while the 10-year Treasury yield is 2.7 percent, an abnormally high spread of more than 5 percentage points. Similarly, the Dow Jones Industrial Average has rarely offered a dividend yield (currently 2.8 percent) that is greater than the benchmark Treasury rate. Before the 2008 credit bubble collapse, this favorable yield differential had not occurred in nearly a half a century. The out-of-favor “growth bonds” seem, at this time, like a particularly attractive place for investors to “look for yield.” 
David B. Anderson is senior vice president and CIO-value equity for Financial Counselors Inc. in Kansas City.
P | 816.329.1500
E | danderson@fciadvisors.com