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.
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.
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 Once the guarantee is withdrawn, however, investors face the prospect of declines in the prices of fixed-income instruments (remember, bond prices go down as interest rates go up).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.
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.