Investment Strategies Newsletter
This past quarter saw a fairly substantial rise in longer-term interest rates, especially in the month of March. 10-year Treasury yields began the month just below 2% (1.97% on 2/29/2012), reached a high-point closing yield of 2.38% on March 19, and ended the month at 2.21%. During this rather abrupt move up in interest rates, the market once again sought out riskier asset classes. Equities enjoyed the best quarterly performance in quite some time. Regardless of which index one chooses, the attraction to risk assets is back on1. So, it should not be too surprising that the riskiest of bond sectors also outperformed the safer ones. The Intermediate Corporate sector of the Barclays Aggregate index returned approximately 2.75% for the first quarter, while the Intermediate Treasury sector of the index had negative returns for the quarter of approximately 0.5%. The biggest winners in the quarter were in the financial sector and the biggest losers were government bonds of the longest maturities– i.e. more than 20 years.
The increase in interest rates that we’ve experienced recently is reminiscent of other short intervals since 2008, where longer US Treasury bonds have corrected to reflect improving economic sentiment in the United States and global economies. As recently as last October, the 10-year Treasury yield increased from a yield of 1.76% on October 3 to a high yield of 2.40% on October 27, an increase of approximately 0.65%. Another more notable "spike" in the 10-year Treasury occurred in the 3rd quarter of 2010 and peaked in early February 2011. From October 5 to February 7 the yield increased from 2.47% to 3.63%, an increase of approximately 1.25%. Nonetheless, rates are a bit higher and some would think that this may be signaling the end of the market’s appetite for bonds, or more precisely, the demand for longer-term US Treasuries. However, before we pronounce the "death" of investor demand in Treasuries, we really need to ask ourselves: what has fundamentally changed to precipitate the notion that investors no longer demand the safety of US Treasuries?
There’s no question that the Federal Reserve Bank’s active purchases of longer-term Treasuries and the uncertainty surrounding a disorderly default of Greek sovereign debt have been key to keeping interest rates low, as investors have sought the safest and most liquid securities in the global market place. However, now that a banking crisis from a worse than expected Greek debt restructuring has been averted (at least in the near-term) in Europe and with better than expected economic data with respect to employment and retail sales here in the United States, the prospects of recessionary pressures have subsided. As a result, expectations for further easing of monetary policy by the Federal Reserve Bank have waned. However, expectations of robust economic growth and the re-acceleration of inflation in the United States are not imminent, in our opinion. The final GDP (Gross Domestic Product) figures for the fourth quarter of 2011 released on March 29 showed an annual growth rate of 3%, which is much better than the 1.8% annualized rate of the third quarter, but not nearly enough to make us change our opinion on the structural economic constraints that will likely limit our economy from performing at full potential2. The structural constraints that pose the biggest hurdles for a healthy economy are: the continuing yearly fiscal deficits in excess of 8% of GDP, the resulting increase in our government’s debt obligations, and the continued high level of unemployment.
The deficits that we have been experiencing since 2008 are worrisome if we continue to spend more than we pay in taxes. The problem will most likely get worse without the appropriate measures to reduce spending and increase taxes. Unfortunately, the political will to take proactive steps in getting our fiscal imbalances resolved does not appear to be palatable to most of our elected officials. Nevertheless, when we do address these imbalances, either through reduced spending or higher taxes, the resulting effect will lead to less fiscal stimulus, which could lead to lower growth expectations, unless the private sector picks up the slack. Meanwhile, the nation’s outstanding debt obligations continue to increase and unless we start producing budgetary surpluses, the debt will not decrease. We will not be generating surpluses in the foreseeable future. So, more and more of our taxes will have to be used to service the debt in the years to come. This will also put constraints on our economy, as the capital used to service the debt could be used alternatively by the private sector to foster growth. Even the government could potentially use this capital more efficiently by promoting programs that create incentives for economic growth, as well as job and wealth creation.
The employment picture has improved over the last year, but is still well below historic norms that typically suggest more sustainable economic growth. In February of 2011, unemployment stood at 9%, and as of this February, it stands at 8.3%3. Furthermore, the number of individuals who were underemployed (includes the unemployed and those that are part-time due to economic reasons) was at 15.9% in February 2011, while this past February that number had improved to 14.9%. Arguably, some of the improvement lies in fewer individuals in the work force actively seeking employment. As job seekers become discouraged at finding employment they no longer look for work and are no longer counted in the pool of potential workers. Naturally, if nothing else changed, the unemployment rate would decrease. However, the improvement is real; we are simply unsure if it is enough to get consumers to feel comfortable about spending money. For an economy such as ours, which is driven by consumer spending, it is important to have as many people as possible working and earning.
So, in our opinion, it is premature to get overly excited about this recent increase in interest rates. We acknowledge improvement in the economic data, but we are also leery about the sustainability of these improving conditions for the reasons mentioned above. Furthermore, the European sovereign debt issue is far from over. The problem has not been solved, only remedied in hopes of a more permanent solution that only economic growth can provide. For the southern European nations, economic growth will continue to be hard to achieve without major changes in the competitiveness of their labor forces. As southern Europe continues to adopt austerity measures to rein in fiscal deficits, major EU economies such as Italy and Spain will most likely be in recession during 2012. This will certainly have an effect on the rest of Europe and will, to a lesser degree, have a negative effect on US economic growth if all of Europe shows signs of recession.
Are Dividend Yields and Bond Yields Comparable?
Prior to this past quarter’s excellent stock market returns, many analysts were making the case for buying equities because the dividend yields generated greater income than the implied yields to maturity of US Treasuries. While that may have been true (and may still be true for some stocks), it does not take into account the relative market risks associated with owning these very different asset classes. First of all, comparing dividend yields of publicly traded companies with those of corporate bonds would be a more appropriate comparison. Most corporations which pay dividends also issue bonds and have inherent credit risk. The US Treasury does not pay a premium interest rate to compensate holders for credit risk. US Treasuries are considered "riskless" securities (in terms of credit risk). In spite of S&P’s downgrade of the US debt obligations from AAA to AA+ (August 2011), the capital markets do not require a yield premium on Treasury securities to compensate for credit risk. Therefore, since comparing dividend yields to corporate bond yields is the more appropriate measure, the case for investing in equities based solely on generating greater income becomes less compelling.
But credit is not the only risk one assumes when buying the stock of a high dividend paying company. In the worst case scenario, when a company defaults, the investor in the company’s equity goes to the end of the line with respect to getting paid back. If a corporation goes into bankruptcy and gets liquidated, the shareholder gets paid last if there’s anything left. The bondholder will most likely get some of his capital back. Remember the old GM, Lehman Brothers, Fannie Mae, and Freddie Mac, just to name a few? These companies were all good dividend payers and their shareholders were left with virtually nothing after their financial troubles.One other consideration is that dividends are not contractual obligations of the company; while coupon payments on corporate bonds must be paid when due in order to avoid a default. Dividends are payable only at the discretion of a company’s board of directors. Each quarter the board declares a dividend or not. They can change the amount of the dividend or suspend it. Interest payments (coupon payments) on bonds are not discretionary—they must be paid. So, if you are an investor in equities solely for the current income produced from the dividend, “don’t count your chickens before they’ve hatched.” During the financial crisis of 2008, many of the banks had to suspend dividend payments or severely reduce them in order to preserve capital. Eastman Kodak, as another example, also had to suspend its dividend after filing for bankruptcy protection. If one had looked at its dividend yield prior to its most recent financial problems, one would have thought it looked attractive. Now, not only has the investor lost the income stream from the dividend, but has also virtually lost his entire capital investment in the event Eastman Kodak does not emerge from bankruptcy as a viable company.
We can sympathize with investors struggling to generate income in such a low interest rate environment, but we would hope there is a clear understanding that investing in dividend-paying stocks is not a perfect substitute for investing in bonds. There are many reasons to invest in a diversified portfolio of stocks (whether or not they pay a dividend), but investing solely because of the dividend yield should not be the principal reason. We believe that as long as one understands the relative risks, it is ultimately the individual’s choice how much risk/reward is appropriate for a balanced approach to investing.
If you have any questions, or would like to discuss these topics further, please do not hesitate to contact your portfolio manager. Happy Spring!
1 Dow Jones Industrial Average gained 8.1%; The Standard and Poor’s 500 index rose 12%; and The NASDAQ Composite gained 18.7% in the first quarter, the biggest first quarter percentage gain since 1991. Barron’s – Saturday, March 31, 2012.
2 Bureau of Economic Analysis, March 29, 2012 news release.
3 US Bureau of Labor Statistics, March 2012 news release.
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