Refining Fixed Income Strategy

I spend a lot of time talking about stocks, but for most people, fixed income investments are overlooked and a crucial part of part of their portfolio.  In fact, nearly half of the assets at MWS Capital are in fixed income.  With low rates and unprecedented US debt creating challenges and unique opportunities, it is important to refine fixed income strategy.  Certainly we have passed the window of 2009 and the Financial Crisis where one could get big yields on the basis of credit risk alone.

When assessing yield and looking at a bond, realize that the long term return of stocks is about 9.8%.  For you stock jockeys, getting a sure 60% of the long run stock return is a basic benchmark, and with the lower risk of bonds, this 5-6% is often a better choice than stocks.  Unique in today's marketplace is a ten year Treasury yield of 3.7% when the dividend yield of sound stocks is about 3%.  While this makes the ten year Treasury unattractive to me, it does not mean I avoid bonds altogether.  Right now I can get that magic 60% of the stock market return in medium term corporate bonds or even in long dated New York City or California Build America Bonds.

A word on the huge amount of debt and interest rate risk:  an after effect of the Financial Crisis is the huge generation of long term money in the form of Treasury debt that will, in my opinion, foster growth-not inflation-in the future.  I know a lot of investors fear inflation, but of the two primary causes, the first being currency debasement, these same investors support high prices and low yields in the Treasury market.  For the second cause, we should have several years of slack in the labor market before we reach excessive employment and escalating incomes.  I believe we are embarking on a period of solid growth with high productivity and that the fear of inflation is misapplied.  In this scenario, real growth will cover the debt created during the Financial Crisis.

Treasuries - Normally the core of a portfolio, but the yields, especially in the short end are just too thin given my scenario of real growth over the next few years.  However 4% on the ten year would be a buying point for me where I would start to feel comfortable shifting from corporates into Treasuries.  Unfortunately it does not seem that we can ever get there with the volatility of Treasury rates near all time lows.  Who could have predicted the ten year pinned at 3.7% with $7.4 trillion of government debt?  When the Fed does begin to raise rates, I do believe the short end will be most impacted, but the long end will only grudgingly rise.  Therefore any future chance to buy longer dated Treasuries at yields 50% of the long term stock rate will meet heavy demand.

Corporates - What I am buying now, although the easy money has been made. A caveat is that I avoid financial bonds in preference for financial stocks, though the debt of the large banks is less risky than it was, and understandably still attractive to some investors.  For me, I look especially for mid-cap industrials in the 5 to 7 year range.   And forget about the short end, here the most secure issues hover at yields near Treasuries. 

Municipals - The easy money had been made, but in the key zones of California, New York, and my home state of Illinois, I am willing to provide financing at the attractive yields of these lower rated states. I would rather lend to New York and California at 5-6% than to the government at 3.5%.

High Yield - Bonds with rates higher than 7% should be viewed as stock, as an investor becomes an equity partner when a lender to a business with high credit risk.  With the huge, albeit justified, rally in high yield debt, I find stocks more attractive. What I do like are distressed real estate deals, but it is hard for individual investors to get into the right situations, an example being the debt of bankrupt REIT General Growth, because most of the deals do not involve public bond issues.   An example of this play was our purchase of General Motors bonds at .10 prior to bankruptcy that are now trading at .33. This is the template of what to look for in distressed debt, something with solid assets that got crunched in the Financial Crisis.