Patience. That's my advice to income investors. I know that a yield of 4.5% on the 10-year Treasury note or 6% on a real estate investment trust, or REIT, looks pretty tempting. After all, the returns on both investments are a full percentage point higher now than they were just a month ago. And I know that every Tom, Dick and guru on Wall Street is yelling "buy on the dip" in the price of fixed-income instruments. But historic market bubbles don't work themselves out in a month. The evidence from 1994-95 -- the last time the Federal Reserve began raising interest rates in a major way -- and from the stock market bubble of 2000, argues that fixed-income markets have just started unwinding the excesses built up in the market since the Fed lowered the fed funds rate to 1% on June 25, 2003. So hold onto your cash. Wait and wait some more. And then, finally, pull the trigger when you can get the kind of peak yields that are available when everything looks darkest for fixed-income assets. That could come as early as the end of 2004 or sometime in 2005. Later in this column, I'll offer my five-step plan to help the patient fixed-income investor prepare for the ongoing climb in interest rates. But first, some background.
Like Giving Money AwayWhy do I call this a fixed-asset bubble? Let's look at some of the numbers. The last time the Fed began unwinding what were then regarded as ultra-low interest rates was in February 1994. The federal funds rate was 3% when the central bank reversed course and started raising short-term rates after keeping them at the 3% level for 17 months. To even approach the current low of 1%, you must return to the 1950s: The effective federal funds rate hit 1% in both 1954 and 1958. For the last 10 months, the economy and the financial markets have been living with the lowest rates in almost 50 years.
There are some huge differences between 1% in 2004 and 1% in 1954 or 1958. On March 17, before the drop in bond prices and the rise in yields, the 10-year Treasury note was paying a yield of 3.68%. In 1954, the yield on the 10-year note was 2.4% in midyear. If you borrowed short in 1954 at 1% and invested long, the spread was 1.4 percentage points. In the spring of 2004, it was 2.8 percentage points, twice as large. Why is that spread important? Because with the Fed virtually giving money away today, big investors were able to borrow two, three, four, seven, 11 times their actual capital at 1% to buy bonds yielding 3.5%. This leverage turned those 2.5 percentage points into a money machine. Money flowed into the Treasury market, sending rates to historical lows and then keeping them there even as the economy showed signs of a revival. Just how low in historical terms? You have to go back all the way to 1961 to find the yield on the 10-year Treasury note below 4%. To find a yield of 3.8%, you have to go back to November 1958. That 1% money didn't flow into the Treasury bond market alone. It went into commodities, where it fueled part of the speculative boom in copper and gold that is now unwinding. Of course, it also helped fuel the rally in stocks.
Capital-Gains Gravy Train DerailedI've looked at spread. Now let's examine capital gains, the other part of the fixed-income money machine that's been in operation since the Fed started to lower short-term interest rates in January 2001. With each move lower in interest rates following that first cut to 6% from 6.5% in January 2001, the price of already issued fixed-income investments climbed. As long as the Fed seemed locked into regularly lowering rates, investors couldn't lose. It was this guarantee of capital gains -- and no capital losses -- that made borrowing hand over fist to buy fixed-income instruments so lucrative. With the Fed supplying the low-cost money, big investors like GE Capital could tap the short-term commercial paper market to borrow at rates close to and sometimes even below the Fed's short-term target. And when there was a guarantee there wouldn't be any loss of capital, this trade was a no-brainer.
Over time, leverage showed up in more and more fixed-income portfolios. Closed-end funds issue just a limited number of shares to raise capital, but can also borrow and then reinvest these borrowed funds. That's exactly what many did, and individual investors flocked to pick up the extra return. About $60 billion has flowed into closed-end bond mutual funds since the beginning of 2001, according to mutual fund tracker Lipper, as individual investors chased the higher yields and returns offered by these funds. How much higher? Van Kampen Municipal Opportunity Trust ( VMO) returned 14.2% for the 12 months ended March 31, 2004. From the first three months of 2004, this closed-end fund returned almost 6%. Not bad for a fund that invests in municipal bonds. In comparison, the non-leveraged ( VMLTX) Vanguard Long-Term Tax Exempt Fund returned 3% in the 12 months ended March 31. But then the closed-end fund's October 2003 annual report notes this:
The trust uses leverage to enhance its dividend to common shareholders by borrowing money at short-term rates through the issues of preferred shares. The proceeds are reinvested in longer-term securities, taking advantage of the difference between short- and long-term rates. With short-term rates at historic lows during the period, the difference between short- and longer-term rates was relatively high. This made using leverage a particularly profitable approach during the period and added to the trust's strong performance.And the approach succeeded because the Fed guaranteed low rates. Once the guarantee is withdrawn, however, investors face the prospect of declines in the prices of fixed-income instruments (remember, bond prices go down as interest rates go up). And the more they're leveraged, the greater those losses can be. The Fed has conceded rates will rise. Result: The Van Kampen Municipal Opportunity Trust fell 13% between April 1 and April 23. All of these leveraged positions in the fixed-income market won't be unwound overnight. Some investors will hang on, hoping that the Fed's interest-rate increases will come more slowly and will be less in scope than feared now. Some investors are waiting for the next bond-market bounce before they sell. Some big investors are putting on more complex versions of the plain vanilla long-short trade to try to extend their gains for as long as possible.
But these positions will be unwound in the months to come. Bond prices will ease, and yields will move higher.
extremely useful Web page with historical interest rates to help you set your fixed-income goals. Above all, be patient.
Five Steps to Get ReadySo what should you be doing as the fixed-income market unwinds its excesses? Here's my five-step plan for the patient fixed-income investor.
- Make sure that you've deleveraged your own portfolio. See if you own any closed-end bond funds, commodity funds, etc., that have been using leverage to boost their returns when that strategy made sense.
- Check your other fixed-income investments to make sure that rising interest rates won't send the company to the wall or put an end to the company's key growth strategy. Check balance sheets to look for large short-term loans that will become more expensive as short-term interest rates rise. A hike of 100 basis points in short-term rates shouldn't be enough to put a company you own out of business. Also look to see if a company that has been growing by acquisition has been using short-term borrowing to fund that strategy. Rising short-term rates could put an end to that growth strategy or force a cut in dividends as the company moves to use internal cash instead of loans.
- Go through your fixed-income portfolio and see what fixed-income investments paying today's low coupon interest rates you can afford to sell now. Your goal is to reinvest the money at higher interest rates down the road. This could mean parking the proceeds in a very-low-yielding money market account for six months or more. So be sure that you can afford the drop in income that the move will bring. Remember that if interest rates go up, the price of any fixed-income asset you own will go down, so selling them later will result in less capital to reinvest at higher yields. This is a tough set of trade-offs. Be careful as you make your decision.
- Set your yield goals for this go-round in the fixed-income cycle. You might decide that a yield of 7.5%, up from today's 6%, on a REIT is high enough to get your money off the sidelines. These goals will depend on the current purpose and construction of your portfolio and other factors, such as how far you are from retirement.
- Finally, be ready to take advantage of that almost inevitable short-lived spike in interest rates that comes when investors who have held on throw in the towel. When the Fed started raising short-term rates in February 1994, the yield on the 10-year Treasury note climbed steadily from around 5.7% to a high of 8.02% in early November. That spike came before the Fed announced its last two rate increases in that sequence. By November 1995, the yield on the 10-year note was below 6% again.