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Ultra low yields have forced investors to do some pretty strange things to their portfolios in an effort to find returns. With some resorting to using their stock portfolios to seek income while simultaneously building equity-like exposure in their bond portfolio.
But BlackRock’s Russ Koesterich and Kurt Reiman have warned that this approach is becoming increasingly risky in some scenarios.
When it comes to generating income with stocks, many investors have pursued equity sectors that may offer high dividend yields and potentially less price swings than the overall market. Think real estate, telecoms, utilities and consumer staples.
But while many bond proxies, such as utilities and real estate, have outperformed in 2014 given the renewed move lower in interest rates, these historically higher dividend yielding sectors have underperformed the overall market since 2011 amid improving economic activity. Says Koesterich.
In addition, while some of the valuation premium of the bond proxy equity sectors has come off in recent years, they are still somewhat expensive relative to recent history. For example, relative price-to-forward earnings ratios for utilities are at the upper end of their historical range.
So what should you do instead, Koesterich and Reiman have some ideas.
Todays Other Top Stories
LearnBonds: – In the trenches – What fixed income pros see from the front lines. – The purpose of our weekly “In the Trenches” report is to provide insight into what fixed income professionals are seeing on the front lines. This often differs from the 20,000 feet perspective provided by many other market information sources. Front line views of the fixed income markets are often criticized, sometimes mocked, in the financial media, but it has been our experience that when all is said and done, the front line view tends to be correct in the end.
Barron’s: – Munis gain on low July new issue volume; Time to rebalance? – It’s been a slow summer for muni-bond issuance, and that’s been to the benefit of muni-bond prices. So far 2014 has produced $172 billion of new bonds, according to Bank of America Merrill Lynch, which is down 14.5% from the same period last year.
Forbes: – Puerto Rico’s public relations headache. – Puerto Rico, on the brink of massive municipal bond defaults, has committed the trifecta of public relations sins: misdirection, finger-pointing, and political infighting.
Bloomberg; – L.A. will appeal pension rollback, mayor’s office says. – Los Angeles will appeal an administrative panel’s decision to roll back changes in public employee pensions that were expected to save as much as $4.3 billion over 30 years, a spokesman for Mayor Eric Garcetti said.
Bloomberg: – California rising catches Pennsylvania at bond crossroad. – California and Pennsylvania are equal in the eyes of Moody’s Investors Service. Yet bondholders are rewarding the Western state as it turns years of deficits into a record surplus, while demanding higher yields from Pennsylvania as it fails to tackle pension costs.
LPL Financial: – Bond yields continued to decline over the second quarter of 2014. – Bond market strength has been broad based in 2014. While prices increased, and yields fell, for top-quality Treasury securities, yields on many segments of the bond market declined even more. The low yield environment that is challenging income-seeking investors persists.
Chicago Tribune: – Investing: what’s driving the boom in bonds. – The biggest surprise in financial markets this year is the strong performance of bonds. You may recall that bond prices fell last year after the Federal Reserve began to reverse its easy-money policies. With yields still near historically low levels, many seers expected more pain this year. But so far in 2014, the Barclays U.S. Aggregate Bond index, a measure of investment-grade debt, has delivered a total return of 3.9 percent. Other segments have done even better.
Bloomberg: – U.S. stocks rise on earnings as bonds gain, ruble drops. – U.S. and European stocks rose on optimism over corporate earnings while bonds advanced, sending German 10-year yields to a record low. The ruble weakened as the European Union and U.S. prepared new sanctions against Russia.
In the Comfort Zone: – In the comfort zone. – This in turn has prompted many investors and asset allocators to take on more credit risk through increased exposure to high-yield bonds. This asset class has also benefited from more favourable economic data over the past 12 months and, more recently, greater comfort among investors with the implementation of tapering.
Investment Week: – ‘Maginot line’ in bond market leaves investors exposed to sell-off. – Bond fund investors should beware a crowded market where there is a growing risk of being caught out by a sharp sell-off in fixed income, analysts at RBS have warned.
WSJ: – U.S. Government bonds gain ground; German bonds rally. – Treasury bonds strengthened along with their counterparts in Germany on Tuesday as demand for haven bonds perked up.
MarketWatch: – Why the 10-year Treasury could yield 4% by Thanksgiving. – Interest rates have fallen this year because the otherwise compelling case for why they should rise was missing one crucial piece — until now.
Investment Grade Bonds
Businessweek: – Verizon claws yield from record sale: Corporate finance. – Verizon Communications Inc. is clawing back some of the extra yield it paid investors in the biggest corporate-bond sale ever with a debt exchange that would extend maturities while trimming interest costs.
High Yield Bonds
Smart Investor: – Junk bonds face turning point. – Markets are riding high but valuations on the junk bond market look stretched.
Fundweb: – Managers clash as high yield valuations turn ‘eye-wateringly expensive’. – Investors are finding it difficult to agree on the outlook for high yield bonds as valuations in the space look increasingly stretched.
MarketWatch: – Refinancing continues to drive U.S. leverage finance market in second-quarter. – High-yield bond issuance reversed the trend of quarter over quarter declines as noted in Fitch Ratings’ new ‘U.S. Leveraged Market Quarterly’ report. Refinancing related issuance continued to be the predominant use of proceeds.
MarketWatch: – Another jump in U.S. HY default rate looms. – A potential bankruptcy filing from another struggling giant, Caesars Entertainment Operating Co., would propel the trailing 12-month US high yield default rate to 3.4% from its June perch of 2.7%, according to Fitch Ratings.
Henderson Global Investors: – Why high yield is sweating in the summer. – While extremely modest numbers in the context of risk assets such as high yield, this is notable because it potentially represents the first negative monthly return for European and US high yield since June and August 2013 respectively. Interestingly, this modest weakness has occurred in an environment of strength in government bonds and fresh all-time highs for the S&P 500 Index of U.S. equities.
ValueWalk: – The outlook for emerging market bonds. – In the latest piece from Research Affiliates, Shane Shepherd, head of fixed income research, looks at emerging market bonds and how they continue to exhibit high real yields and improving credit quality. With emerging market currencies likely to strengthen, the article explains why emerging market bonds issued in local currencies might be a solid addition to a diversified portfolio.
Financial Post: – Interest rate rise may not rattle emerging markets. – Emerging-market investors might be a bit worried about the U.S. Federal Reserve’s next few moves, especially if it leads to higher interest rates south of the border.
MarketWatch: – It’s not just hedge funds that own Argentine bonds. – Hedge funds aren’t the only investors with money on the line as Argentina scrambles to avoid a bond default.
Bloomberg: – Loomis hoards easiest-to-sell bonds as Yellen plots exit. – Loomis Sayles & Co. is so convinced that bond prices are about to fall that it’s hoarding a record proportion of easy-to-sell securities in its flagship debt fund.
Digital Journal: – Pay less to earn more: 3 low-expense funds to buy now – Best of funds. – In this article we will discuss about fund expenses. Fund expenses are paid indirectly from fund assets throughout the year. Lower charges will obviously allow larger share of the capital to be invested and also help investors in earning higher profits.
Continue to wonder if a Fed policy error is being priced in with these recent UST moves
— David Schawel (@DavidSchawel) July 29, 2014
Bonds doing the exact opposite of what I expected this week. At least the front end is still relatively weak. — Ed Bradford (@Fullcarry) July 29, 2014
In our review of insured PREPA bonds this week, Berkshire Hathaway remains the gold standard but we think Syncora is undervalued in market
— Muni Market Advisors (@Muni_Mkt_Advis) July 29, 2014