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Quantitative Easing And Bonds

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fed-reserveYou may have noticed that when the Federal Reserve began the program called “quantitative easing” that your Treasury yields started to falter, eventually becoming negligible.  Now it hasn’t been all bad, because you probably also noticed that the price of your Treasury bonds went up.  This article will explain what’s going on, and what you can do to replace Treasuries that aren’t yielding anything.

The Fed’s theory is that by constantly going into the bond market and buying up $85 billion worth of Treasuries (or other assets, but in this case, we’ll stick to Treasuries) every month, bond prices will rise, and bond yields will decline.  This causes interest rates in general to decline, making it easier for all financial institutions and businesses to borrow money.

So the idea is that the economy gets stimulated because it is so cheap to borrow money. Unfortunately, for people who rely on bonds for fixed income, that yield gets pushed down to almost zero.  In theory, as the economy improves, interest rates will rise, and bond yields may also.  However, the recovery has been weak (to be generous), and any thought that yields or rates will rise anytime soon just isn’t realistic.

Employment has been very weak.  Job creation is more focused on part-time than full time employees.  The Labor Force Participation Rate, which measures how many people are actually in the workforce actively seeking a job, has fallen to its lowest level since 1978.  That means more people have left the workforce since 1978.  If they aren’t in the workforce, then they aren’t earning money, which means they aren’t spending money, which means businesses aren’t seeing organic growth, which means businesses aren’t hiring, which means businesses don’t need cheap money to expand.

All of which means that the Fed is likely to continue with quantitative easing for some time.  That is not good news for fixed income investors, especially those with low risk tolerance.   The beauty of Treasuries was that they were considered risk-free, because they were backed by the Federal government.  You could get a decent risk-free yield out of them as a result.  Now that yield has gone away.

This, by the way, is why the stock market has been booming.  The bond markets are much larger than the equity markets.  So people sell Treasuries because they aren’t yielding anything, and jump into dividend-paying stocks in the equity markets.

But what if you don’t want to take on equity risk? There are a few things you can do to reallocate the funds you have in Treasuries to replace that lost yield.  One place to look is short-term municipal bonds.  Although yields here tend to be rather low, they are often tax-exempt at all levels, which raises their taxable-equivalent yield.  Treasuries are not exempt from Federal taxation.  You should be careful what muni bonds you purchase, however.  I am a big fan of ETF that serve this asset class because they provide for diversification.  The last thing you want is to buy a single muni bond in a city like Detroit, and then be exposed to that kind of risk.

Another place to look is Preferred Stock.  These are stock-bond hybrids.  They trade like bonds in that the underlying stock price tends to trade in a very narrow range.  They pay taxable dividends in the 5% – 10% range.  They also are ahead of the common equity in the capital stack in the event of a default or liquidation.

About Lawrence Meyers

lawrence meyersLarry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes.  You can reach him at pdlcapital66@gmail.com.

 

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