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The Week in Review

One of the questions I get most from clients is how to generate yield when the Fed is on hold with rates at zero. For a while many defensive clients were content receiving their 3% annual yield from Treasury bonds, but the Fed’s most recent meeting minutes shows that the Fed’s pace of bond buying may soon slow. While I do not think tapering is likely before year end (unless economic data accelerates significantly) the bond market is forward looking and already beginning to price tapering in.

Smaller Fed purchases of Treasury bonds will mean that bond yields go up and bond prices go down. Bonds have been in a multi-year bull market, and we may now be on the cusp of a multi-year bear market.
The most important indicator to watch is the 10-year yield, which cracked the 2.10% level this week for the first time in a year. If we continue to hold above 2.05% in June, the top is likely in for bonds and borrowing rates will be on the rise for everyone, including the US Treasury.

So, how am I playing a potential bond bear market?

First and foremost, I am trimming my client’s exposure to Treasury Bonds across the board. I have been reducing client’s exposure to TLT for the past week, and will continue to scale out of it as long as the 10-year yield is above 2.05%.

I am taking some this freed-up capital and moving into short duration, high-yield corporate bonds. The shorter duration a bond has, the less sensitive it is to rising rates, which will keep the market-to-market volatility of these bonds low even if long dated treasuries sell-off significantly. These can be traded through ETFs, such as the Guggenheim BulletShares series (BJSD matures in 2013, BJSE matures in 2014), and offer annual yields of 4.25% right now. The diversified nature of these ETFs, along with the fact that high-yield bond defaults are at multi-year lows, make me feel comfortable holding these bonds for the fixed income investor willing to take a little bit of risk to get a higher yield. I am also allocating a portion of client’s fixed income portfolios to senior floating rate notes via ETFs like BKLN, which offers a 4.79% yield that will remain safe even in a rising rate environment.

For the extremely risk-adverse investor who insists on exposure to the US Treasury bond market I am employing a put-write strategy on TLT, a US Treasury Bond ETF. Selling a put on TLT allows us to pick a level we are willing to buy into the Treasury Bond market and begin collecting coupon payments, but does not give us exposure until TLT trades below the strike we sold. While TLT remains above our put strike we not only have no exposure to Treasury Bonds, but also collect income from the premium we received for selling the put.

Many people ask me about buying dividend paying stocks or MLPs in order to get yield, which I am extremely cautious about. This week the Utility Sector (XLU) was down 3.03%, and the ALPS Alerian MLP ETF (ALMP) was down 3.36% with the S&P 500 down 2.18%. This demonstrates how interest rate sensitive these stocks are and tells me that they will see more downside if rates continue to rise. I am much more interested in stocks that will thrive in a rising rate environment, and one such sector is the Financials (XLF). The financials closed the week down just 0.65%, demonstrating relative strength, and are some of the stocks I would be interested in buying should the market continue to dip next week.

Comments

Bill Luby said…
I always appreciate your commentary, Brian. FWIW, the ST HY bond tickers are BSJD and BSJE. The full list of relevant products is available at http://guggenheiminvestments.com/products/etf/product-list

Cheers,

-Bill
Brian Stutland said…
Thanks Bill. You are right about the ticker symbols. Editors error on my part. And, thanks for the link to the Guggenheim Funds. Hope people take advantage of it.

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