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How to Find Safe Yields in an Interest Rate Sensitive World

Interest-Rates / US Bonds Nov 29, 2013 - 04:30 PM GMT

By: Don_Miller


While Mr. Bernanke's policies have taken a toll on seniors and savers, his mere mention of the word "taper" last spring did us all a favor. It sent interest rates rising, bond and stock prices tumbling, and in the days that followed, the Fed went into damage control—quite a lot of hubbub for something the Fed was only pondering. What happens when they announce they actually did something?

To pinpoint the answer, the Money Forever analysts and I looked at the performance of utilities, a longtime favorite of conservative investors. Because of egregiously low yields, investors had moved billions of dollars out of fixed-income investments and poured into bonds and dividend stocks—utilities in particular. That caused utilities to become interest-rate sensitive, meaning they began to behave like bonds: falling when interests rates rise.

We recommend holding at least 30% of your nest egg in cash or cash alternatives. Unfortunately, if 30% of your portfolio is earning a measly 1% or less (the going rate on most cash instruments), the other 70% is up against a Herculean task. That portion would need to earn just under 10% in order for your entire portfolio to yield the old-line goal of 7.2% (the rate at which, compounded, your portfolio doubles every 10 years).

The solution: find cash positions with higher yields that are less sensitive to rising or falling interest rates. That way, the rest of your portfolio won't have to work so hard, and you won't be tempted to take risks ill suited for a stable retirement.

You might be thinking, "That's a nice idea, but where are these ultra-safe cash alternatives offering healthy yields regardless of interest rates?" Rest assured, they exist, but as Doug Casey would say, you have to look where no one else is looking.

With that in mind, I sat down with my friend and colleague Alex Daley to bring you some clear answers.

Dennis Miller: Alex, it's nice to speak with you again. I would like you to elaborate on one of the ideas we've discussed. Many folks are bewildered and frustrated, waiting for juicy Treasuries, bonds, and 6% CDs to come back. In the meantime, they are pouring their money into investments that have become interest-rate sensitive. What advice can you offer these folks?

Alex Daley: Those kind of interest rates are only coming back if one of two things happens: if the economy starts booming, in which case the loose-money policy of today will feed much larger price inflation than we are already seeing, and rates will be raised in reaction; or if there is a loss of faith in the US currency or our government's ability to pay debts from the outside, and investors start demanding higher rates to compensate for that risk. It's a fine line the Fed is walking with policy, but it could walk it for a long time.

In other words, low rates are probably going to be with us for a while. There likely won't be a sudden jump. But if we pull off the monetary stimulus at some point, they're going to start heading back up, because if you're China or India, do you want to add to your stockpile of American debt?

Rates are already so incredibly low that even the slightest increase will send a lot of investments reeling. When the 10-year Treasury is yielding anywhere from 1.66% to 2.98% like it has been this year, then a 1% jump in rates is a huge relative increase.

Two things will follow a move like that:

  1. The price of those bonds will fall quickly because investors are willing to pay less for that yield. After all, they could find better returns elsewhere.
  2. The price of things that yield close to the same amount, like traditional blue-chip dividend stocks, will also drop in tandem.

Now, if you own a whole bunch of bond funds, you can easily tell what your real exposure is. You can measure (or read the prospectus of your fund, as they do it for you) the "effective duration" or just duration of your fund. That will tell you, in no uncertain terms, how much you're likely to lose when rates rise by 1%. A duration of 7—about the average for most bond funds—means that a 1% increase in nominal rates like the 10-year Treasury everyone uses as a benchmark will mean a 7% drop in your portfolio.

Generally with bonds, the shorter the maturity, the better they do when rates are rising.

For instruments other than bonds, the risk is harder to quantify. The XLU fund, which is full of utilities—often called "widows and orphans stocks" in part for their supposedly low volatility—reacted sharply to rising rates earlier this year.

There's one rule of thumb to apply to both categories: the higher the yield is relative to the 10-year Treasury, the safer it is from rising rates. So, instruments that yield 3% today are more dangerous than those that yield 5% or 6%. That may sound counterintuitive, but when rates are rising, investors should understand this.

With bonds, the best way to measure this sensitivity is to find instruments with high yield-to-duration ratios. Those are the investments that recover most quickly from a dip because of rising rates.

So, to get back to your question, chasing yield in and of itself is not a bad thing. There are categories of yield that are relatively resistant to interest-rate creep. But it's important to understand what drives that correlation, lest you get caught with your proverbial pants down (say, holding a bag of long-dated muni bonds—bad advice I've seen from far too many stock pickers).

There are lots of good choices, in bonds, in stocks, and in alternatives off the market.

Dennis: During a presentation you gave at the most recent Casey Summit, you really emphasized moving out of our comfort zone and investing in different vehicles. You suggested Lending Club to us some time back, and we're seeing excellent returns. In addition, I've been writing covered calls on stocks and had some terrific returns between dividends and the income from the calls.

Some readers may be a tad squeamish about out-of-the-ordinary investments. What do you suggest for these reluctant folks?

Alex: Dennis, I know one of your core beliefs is never investing in anything you don't understand or are uncomfortable with. You and your team do a great job educating in straightforward terms so your subscribers can easily weigh the risk and rewards for themselves. Ultimately, that's what investing comes down to: How risky is this? What's my likely return? If you can answer those two questions, you should be comfortable with an investment.

So, take your example of Lending Club. It's pretty easy to understand: they make personal loans to people; their rates are a little below what banks can lend at because they sell the loans directly to investors like you and me over a simple website; and they don't have 3,000 branches to support and big margins to maintain. Essentially, the company is much more efficient as a middleman than any bank can be.

What's the risk? Well, look at it qualitatively first. People can default. That's the risk. But most people try their best to pay their debts. So only a portion of people will fail to pay back their loan. With the tools you can buy $25 slices of 1,000 loans instead of lending your brother-in-law $25,000 in one shot. That spreads the default risk out.

Looking at the numbers, it stands up, too. It's why Lending Club claims that no investor with more than 800 notes (i.e., slices) has ever lost money on their investment. As you research the loans, you can find lots and lots of data on defaults to ensure you know what you're buying. Each class of loan has historical default information, and you can see how it stacks up to returns, and what your likely net return is.

You can talk to other investors on the many blogs that cover people's experiences. You're an investor, Dennis, and you mentioned that you're currently earning a 9.8% return on your invested capital and have just increased your allocation. I began investing with them just months after the company was founded, and I've seen very similar returns year in and year out.

So you can understand the risks, even if you aren't a banker. You can see the returns. And both are backed up by lots of data.

Like any investment though, start small and get comfortable firsthand. That's the only way to be sure you're making the right decision.

Dennis: One final question. We discussed CDs and the thought of interest rates going back to "normal." You said that today's low rates are the new normal. If the Fed continues to buy our debt and interest rates rise, things like 6% CDs might become available again. However, we agreed that jumping right back in to them could be risky. Can you elaborate on that?

Alex: Carter-era inflation is a good clue as to what lies ahead. Let me refresh your memory.

1977—6.5% inflation

1978—7.6% inflation

1979—11.3% inflation

1980—13.5% inflation

1981—10.3% inflation

You put a great graphic in a recent article that shows a person buying a $100,000, five-year CD with a rate of 6% on January 1, 1977. That person would have had a net loss of 25.9% in terms of buying power when the CD matured, after factoring in their interest income. Investing like that will have a real negative effect on your retirement lifestyle.

As the Federal Reserve continues to buy more of our country's debt, it will be increasingly difficult for it to keep interest rates under control. Foreign governments like China and Russia will demand higher rates or they will unload our debt, causing inflation.

Finding investments that will have good yields regardless of the direction of interest rates, that have low effective duration, and that are much more liquid than a CD or long-term bond is a much better approach. This will allow you to be responsive to rates without having to sit in cash, waiting on the sideline as the world changes. If inflation starts to rise, like in our example, you can move more heavily to equities, which will see dividend increases under those circumstances.

Or, if rates start to rise first, you can rotate into investments whose yields are rising in tandem. The artificial bond ladders you build with things like target maturity funds, short-term consumer debt like Lending Club, floating-rate funds, bank loans, etc. are tools to prepare your portfolio for the change that's coming without having to sit on the sidelines.

You CAN sleep at night AND find yield, if you make sure to measure the right things.

As I mentioned in my Tucson presentation, your team is doing a great job of finding these kinds of investments now in places where most folks aren't looking. That adds a great dimension of safety.

Dennis: Alex, thank you for your time.

Alex: My pleasure.

Grabbing yield wherever you can find it sure is a good proposition… but the fact is that those high yields and above-average gains aren't always found in the same place. Trying to catch a bull run in a certain sector can be like firing at a moving target.

However, there are those very rare times when opportunities present themselves in every sector we follow—and this is one of those times. Our team spreads the net wide to find yield in all sectors it makes sense, and lately there have been several good investments added to our portfolio.

We, like you, strive for bulletproof income and we have found several opportunities out there to grow your nest egg while protecting it. And you can get access to these investments today, risk-free, by trying Miller's Money Forever. With our 90-day trial you get access to the complete portfolio, our special reports dedicated to issues facing investors today, and all of our archives. In them you'll find several interviews like this one with experts from all sectors.

So, try it today. You risk nothing and you will find stocks poised to make you the returns you want, with the protection you need.

© 2013 Copyright Casey Research - All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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