Sunday, February 27, 2011

The 14 Percent Solution

Bond Mavens United
Stock analyst Meredith Whitney grabbed headlines recently with her perilous prognostications for the U.S. Municipal bond market. Hundreds of billions in municipal defaults will plague the country over the near term is essentially what she has been saying to the media.
While I disagree with her headline grabbing prediction (as do most reasonable analysts), many purveyors of municipal debt have said the effect of this will be to move municipal rates up thereby creating a buying opportunity for tax-free income investors. It is true municipal rates have jumped over the last few months, but is this a buying opportunity? I don’t think so.
Currently, the major risk with municipal debt (corporate and government included) is not credit risk but interest rate risk. Yields have recently increased but are still deep in the pygmy range. That is what will eventually hurt you (your net worth specifically).
James Grant, a leading authority on interest rates and bond markets, along with Bill Gross from PIMCO and others have essentially been saying the same thing. Stargazers beware; a bear market in bonds is in the offing - a secular move from decreasing interest rates to an environment of sustained interest rate increases.
Central bankers have lowered the cost of money for 30 years now, following global disinflationary forces downward, but also allowing for increased leverage due to lower real interest rates. Today however, yields have less to do with disinflation and more to do with providing fuel for an asset-based economy. 10-year real interest rates fell from over 5 percent in the early 1980s to just less than 1 percent recently.
But the tide is at the turn. U.S. Government debt has experienced recent price declines (yield increases) as the European Central Bank said monetary policy has to be monitored, and if needed, corrected. China’s central bank raised reserve requirements for lenders for the second time this year to counter inflation and curb property-price gains. German producer prices are increasing at the fastest pace in more than two years.

Inflation will be a dominant theme as we look ahead, global inflationary forces will generally push rates higher around the world. A Morgan Stanley gauge of stocks such as Archer Daniels Midland Co. and Deere & Co. meant to rally when inflation expectations match Federal Reserve targets added 46 percent since August 2010, almost double the Standard & Poor’s 500 Index.  While emerging-market equities beat developed countries every year in the past decade, except in 2008, you should not count on that now as Brazil, Russia, India and China battle higher food and commodity inflation.So what is one to do? Confront the risk and reward tradeoff, look hard at alternative strategies. Shorten the average maturity (duration) of your fixed income investments. Look at alternatives, such as a high quality mortgage REIT like Annaly Mortgage (NLY). This company greatly weathered the great recession, ROE looks good and using measured leverage has kept the stock in a fairly tight range, all while paying a 15 percent dividend. Buy blue chip stocks that pay higher dividends. There are options to explore that can mitigate the deleterious effects of higher interest rates and inflation.

C Blakely CFP®, CTFA 02/2011

Sources: Grant’s Interest Rate Observer, PIMCO, Bloomberg LP