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US Interest Rate Spike and What to Do About It

Interest-Rates / US Interest Rates Jun 09, 2007 - 12:06 AM GMT

By: Roger_Conrad

Interest-Rates

The 10-year Treasury note yield is again more than 5 percent. And while the benchmark is off its high for the day—it reached 5.24 percent at one point—the fallout has at last reached the rest of the income investment universe.

The Dow Jones Utility Average is now down about 9.1 percent from the all-time high of about 537 that it set in late May. The typical US real estate investment trust (REIT) is down 13.5 percent, and many bond funds are showing similar carnage, particularly those with the highest duration—i.e., leverage to interest rates.


As I wrote last week, the current rate spike has come as a shock to much of the income investing population, which seemed to be willing to pay almost any price for traditional yield investments just a few weeks ago. That's the reason the damage has been so swift and severe. But it's far from the end of the world. Rather, it's a time to assess what you own and get ready for buying opportunities that will inevitably appear.

In the last few issues of my monthly print advisory Utility Forecaster—as well as this advisory, Utility & Income—I advised investors to take some money off the table as long as the rally continued. My idea wasn't to abandon positions in good businesses but to scale back anything that had become an overweight portion of portfolios.

Thus far in this correction, that's proven to be good advice. The income investing sectors that have appreciated the most in the past year or so have been the worst hit, particularly the REITs and the utilities to a lesser extent.

Meanwhile, sectors like the Canadian trusts—which have been recovering from big hits in late 2006—have been least hit. The benchmark S&P Toronto Stock Exchange Income Trust Index (SPRTCM), for example, is down only about 4 percent from the highs set in late May.

That level, incidentally, actually exceeded where SPRTCM stood in late October, before Canada's Finance Minister Jim Flaherty announced trusts would be taxed as corporation beginning in 2011, setting off a $30 billion-plus decline in trust market values.

Energy, too, has been a haven of sorts. The XOI—an index of the biggest oil companies, which typically pay substantial distributions—is down only around 3.5 percent from its June 4 high.

Energy always marches to its own drummer. That's what's made dividend-paying energy stocks such a great hedge against rising interest rates in the past, including Super Oils, utility/producers, limited partnerships, and oil and gas producing Canadian trusts. And it's why every income portfolio should have some.

In my view, the key to surviving this rate spike—as long as it lasts—is having a balanced portfolio of high-yielding plays backed by good businesses. That means owning the best of a wide range of groups in roughly equal proportion, including some of the sectors that are likely to be hit.

Even stocks and bonds backed by good businesses can get hit as momentum followers bail out. And though things seem to have calmed down this afternoon, there's a strong possibility that there will be more selling next week.

One reason is sentiment. Influential bond analyst Bill Gross stated this week that he forecasts a move to 6.5 percent in the benchmark yield, and he's proclaimed himself bearish on bonds. That alone scared a lot of people and no doubt contributed mightily to the selling wave this week.

But there are also some fundamental reasons to look for a higher 10-year yield, at least in the near term. One is the fact that central banks abroad have started lifting rates to control inflation pressures.

This week, the European Central Bank—whose efforts are largely directed at influencing the euro—lifted its benchmark to a six-year high. New Zealand also raised rates unexpectedly.

With the US dollar already slipping fast against major currencies, rising rates abroad make it very difficult for the US Federal Reserve to consider cutting rates, which, up until the past month or so, was the clear expectation on Wall Street.

Based on federal funds futures, the market now gives just an 18 percent chance that the Fed will cut the fed funds rate to 5 percent by yearend. That's down from odds of 40 percent in late May and 98 percent in early May. Again, that's a powerful shift in sentiment and argues for more selling not only in the benchmark 10-year Treasury note but in other income investments as well.

Also arguing against lower bond yields are recent signs of stronger economic growth in the US and other nations. In fact, market sentiment is growing that we could see an acceleration of growth in the coming months.

Some inflation bulls believe now that the impact of lower wage rates in China and other developing nation exporters has played out as a depressor of inflation and that rising commodity prices will now start to send overall inflation much higher. Were that to be true, we'd no doubt see even more selling in income investments across the board.

DÉJÀ VU ALL OVER AGAIN

As an advisor and an investor myself, my focus is always on buying the best businesses I can find. Basically, I'm a “bottom up” guy who likes to pour over financial documents, question executives and swap perspectives with analysts and others who are experts on various industries.

In the near term, the stock market is in many ways a popularity contest, with institutions and momentum investors moving from one hot group to another. Over the long haul, the stock market is a weighing machine where value always wins out.

If a company's business continues to grow at a healthy clip, investors will sooner or later catch on and its share price will move higher. The move can be delayed by trends in the overall market. But a good, growing company will always move to higher ground when the cycle ends.

If you have the patience to hold on and the confidence in the underlying numbers, you'll always do better by buying and holding a good business rather than attempting to trade in and out. You can take money off the table when something appreciates too rapidly and add it back when its price comes off. But you're far better off hanging on than trying to second guess the overall market, which, as we've seen time and again, can literally turn on a dime.

That kind of advice is, of course, very difficult to follow when the market is in a volatile mode. Income investments are generally steadier than other sectors of the market. As long as the yields hold, they provide a value floor for the share price. And the cash received makes waiting for a turnaround much easier to take.

You can throw all that out the window, however, when interest rates start rising or, worse, spiking. Then, the temptation is to imagine something fundamental is going wrong with your holdings and to throw out the good with the bad.

It's too early to forecast the exact direction or magnitude of the current rate spike. It could well have already peaked, or it may well go on to meet Mr. Gross' target of 6.5 percent.

One thing we do know for certain is a rate spike always sows the seeds of its own reversal, even in the most-extreme cases. That's because a rising cost of money ultimately depresses growth. The markets come down, slack builds in the economy, inflation lessens, and interest rates fall again.

Each of the last four years—2003, 2004, 2005 and 2006—we've had a rate spike. Last year's eventually carried the benchmark 10-year Treasury note yield as high as 5.3 percent. At that point, many pundits proclaimed Armageddon was at hand and advised a massive bailing out of income investments.

They were dead wrong, just as they were following similar spikes in 2003, 2004 and 2005. Of course, even a stopped clock is right twice a day. And it's certainly possible this spike will go on a while longer.

But ultimately, the bond market will have its way and check both economic growth and inflation, just as it's done in the past four years and just as it did in the early 1980s. Then Fed Chairman Paul Volcker pushed rates skyward. But it was the bond market that ultimately made it more expensive to borrow and ultimately gutted growth.

In my estimation, it's extremely unlikely we'll see anything close to early '80s levels for interest rates. For one thing, despite the fretting about inflation, we're only at a fraction of that level.

Moreover, the world's central banks are anything but disciples of former Fed Chairman C. Arthur Miller, who basically let inflation get out of control in the '70s and set up the need for the early '80s crunch. This week's upward push on rates is certainly clear evidence of that.

Rather, I think this rate spike will be still more déjà vu, a virtual repeat of the spikes of the last four years. The 10-year yield will likely go a bit higher, possibly to 5.5 percent or more, and income investments will suffer as they climb. But sooner or later, the rising cost of money will do its work on the economy. We'll see signs that things are cooling off, and rates will move lower again.

The jump in rates will bring prices for utilities, REITs and other income investments lower. That will, in turn, set up a new buying opportunity for stocks and bonds backed by good businesses. Then as rates back off their highs, these investments will again move to new highs.

The key remains the health of the underlying businesses. As long as that's good, recovery is inevitable, no matter what happens in the near term on the interest rate front. Conversely, if fundamentals are deteriorating at one of your holdings, don't wait for rates to fall before bailing out.

The other caveat here is not to be in a hurry to buy this market. Like I say, stocks and bonds backed by good businesses will always move higher over time. In fact, even if you buy at the worst possible time in the interest rate cycle, you're ultimately going to be made whole if you're patient.

Until this rate cycle plays out, however, odds are prices of income investments are going lower. And with cash and money market funds yielding between 4 percent and 5 percent, it's going to pay to keep at least partly on the sidelines.

Below, I sum up the prospects of several income investment groups that should be a part of everyone's portfolio in some form.

UTILITIES— We're getting close to the five-year mark from the 2002 lows in the sector. The good news is fundamentals for power, gas and water companies haven't been this strong since the mid-'60s, and things are still moving in a positive direction.

The bad news is valuations are also back to levels that prevailed in that era, with dividend yields for many good companies down in the 3 to 4 percent range. As I pointed out last week, my view is the long-term health of these companies is going to depend on their return on the hefty capital investments that must be made in the next few years.

Those that can earn a good return—either through regulated or unregulated means—will be among the most reliable growth stocks on the market. That includes utilities operating in good regions like the Southeast and those involved with alternative energy like FPL GROUP. Those that don't earn a good return will flounder.

Ultimately, that distinction will prove far-more important than what happens to utility stocks during this rate spike. Remember that no major bear market in utilities has ever occurred unless there was severe deterioration in the fundamentals, as there was in the '30s, early '70s and early 2000s.

Interest rate-inspired selloffs have never lasted more than a year and typically take things down 15 to 20 percent. But the best utilities have always finished every cycle on higher ground, and there's no reason to expect things will be different this time around.

REITS— The REITs' run has lasted even longer than that of utilities. Unfortunately, valuations are even more stratospheric. Back in early 2000 when the rally began, yields for good REITs were 6 to 7 percent. Today, some are less than 2 percent.

In 2000, most REITs traded at around the book value of their assets. Today, they sell for three or more times that level. I don't look for a day of reckoning to drive valuations back to 2000 levels. 

For one thing, the industry has a whole new group of buyers--namely institutions--who are willing to pay higher prices in part because of REITs' takeover potential. The only REITs I'd be a buyer of now are apartment REITs such as MID-AMERICA APARTMENT COMMUNITIES, which still yields over 4 percent, and Canadian REITs.

Apartment REITs in the US have lagged other REITs largely because of low mortgage rates. But now rents and occupancy are on the rise, fueling profits.

Canadian REITs are benefiting from a robust economy there and the rising Canadian dollar, which boosts the US dollar value of dividends and share prices. Good ones, such RIOCAN REIT, yield in excess of 5 percent.

CANADIAN TRUSTS— This is the cheapest group in the high-income universe by far, thanks to the combination of falling energy prices last year and the government's decision to tax them as corporations beginning in 2011. That plus their connection to strength in commodity prices should protect trusts' share prices from this rate spike.

My favorites are the better-positioned oil and gas trusts such as ENERPLUS RESOURCES, which should be held in combination with trusts outside the energy sector like YELLOW PAGES INCOME FUND.

HIGH-YIELD ENERGY— Outside the Canadian oil and gas producer trusts, this is another group that should weather the storm in style. Energy prices are on the upswing again and should remain that way, particularly if hot weather continues to heat up demand for natural gas in the Northeast.

Super Oil stocks such as CHEVRON CORP are safe enough for even the most-conservative investors, but there's a wealth of other plays paying solid distributions as well. Rising energy prices will counteract the impact of rising interest rates, making these a great way for income investors to hedge their exposure. 

BOND FUNDS— Here, the key is duration, which measures how much the overall portfolio's value is impacted by moves in the benchmark 10-year Treasury note yield. Funds with low duration (five years or less) suffer very little when rates rise.

My favorite open-end bond funds—which mint new shares in response to investor demand—are all in the VANGUARD group. In the closed-end arena, I like ING PRIME RATE TRUST, which adjusts its yield upward when interest rates rise.

Note that if rates continue to rise, closed-end bond funds' market prices will swing from premiums (above) to discounts (below) the value of their portfolios, or net asset value. That will be a great time to buy them.

COMMUNICATIONS STOCKS— This group staged a mighty comeback during the past 12 months from nearly six years of sector depression. But in my view, these stocks are still extremely undervalued relative to future growth potential, as industry sales expand and market power basically consolidates to one cable television and one phone company in every area. The best for yields are the rural phone service providers, including CITIZENS COMMUNICATIONS.

CASH— Cash is king when interest rates rise. It holds its value and, with money market rates in the 4 to 5 percent range, it's not exactly painful to hold either.

 

By Roger Conrad
KCI Communications

Copyright © 2007 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.

KCI has assembled a team of top investment analysts to create the finest financial news service possible. With well-developed research skills and years of expertise in their particular fields, our analysts provide quality information that few others can match.


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