Monday, August 2, 2010

Coping with the Federal Reserve's Jihad Against Savers & Responsible Americans & the Potential Major Correction in Bonds Down the Road

A WSJ article pointed out the obvious, the yield alternatives for savers are bleak and becoming bleaker. Bank of America slashed its five year CD rate by 1/2% to 1.75% and its new 3 year CD rated declined to 1.1%. A two year treasury note hit a record low last Friday at .539%.

The 3 and 6 month treasury bill yields are .147% and .198% respectively. A ten year treasury is at 2.905%. The Vanguard Prime money market fund has a seven day yield of .12%. Fidelity Cash Reserves is at .1%. Taxable Money Market Funds - F Huge sums of money are sitting in these money funds earning those rates. An online savings account may yield around 1%, less if maintained at a branch location.

As of 7/30/2010, the SEC yield for the Vanguard Total Bond Market ETF was 2.87%. Vanguard - Total Bond Market ETF (BND) Vanguard's Intermediate term government bond ETF had an SEC yield of 1.81%.

The Federal Reserve's Jihad against savers is likely to continue for at least several more months, continuing to punish those who had no role in causing the financial crisis in order to provide assistance to those who did. The punishment occurs of course in the forced wealth transfer from the responsible citizens to the irresponsible, greedy and reckless. Even after the Fed ends its Jihad, those savers who piled into bond funds seeking any kind of yield will be skewered again as those investments lose value as interest rates rise.

The general consensus is that the low yields indicate economic weakness for years to come, an American version of the Japanese economy from 1989 to date. I suspect that this opinion is based on an incorrect conclusion currently being drawn from the low interest rates and bond yields prevailing today. The low yields are more due to the Fed's zero interest rate policy for federal funds that has dramatically lowered all short rates to abnormally low yields. This in turn has a caused a stampede into bonds, as investors search for yield, a feeding frenzy reminiscent of the final stages of a parabolic move in any asset class, such as the upward spiral at the tail end of the last long term secular bull market in stocks in the late 1990s.

It is more the overwhelming demand for bonds caused by the Federal Reserve's policy, and the prospect of that policy continuing for an "extended period" of time, that is causing the formation of an unprecedented bond bubble across the spectrum. The low yields do not reflect so much an opinion on the prospects of future economic growth as the confluence of abnormal demand for bonds and the Fed's Jihad against savers. Over 700 billion dollars has flowed into bond funds over the past 18 months.

If that turns out to be a correct forecast, then the Fed's policy will end up being a disaster for individual's failing to exercise appropriate caution, first in depriving them of an acceptable rate of return for their savings for several years and then causing a bond bubble to inflate, drawing individuals end near or at the top, only to burst it with a greater than expected rise in short term rates later on to combat emerging inflation.

One problem about the future is that it is ultimately unknowable. So, given my particular financial situation, overall knowledge about securities, daily attention to what is happening in the world, and my tolerance for risk, I will plan for many alternate scenarios. One scenario, viewed as unlikely but possible, is a long period of low inflation and occasional deflation, sub-optimal and stagnant economic growth, and abnormally low interest rates. For this type of scenario, I want long term investment grade bonds and bond funds. I will also continue to stay out of debt as one important way to deal with this kind of scenario. I am naturally inclined to avoid debt anyway so this is easy for me to do, and I have none now.

Debt, particularly excessive debt and leverage, can be a hazardous to one's fiscal health in a deflation scenario. For example a person buys a house for $400,000, now worth $300,000 and has a mortgage of $380,000. The borrower's income growth is virtually non-existent, and their job is not exactly secure. Some bills are resistant to going down, however, such as medical insurance which still increases at a rapid rate, college tuition for the kids, and property taxes. The fixed coupon payments of the mortgage obligation become harder to service with virtually nothing in the way of income growth, interest on savings or appreciation in investments over their cost of purchase.

In addition to staying out of debt, I have bought a large number of securities that may do well in the low inflation to deflation economic scenario. The following is a brief summary of my plan for this type of scenario, which interestingly involves some securities that can swing both ways particularly when purchased at advantageous prices. If I had to implement a plan now with new purchases, I would have to do it differently. Fortunately, many of these purchases made in furtherance of this plan were made at far more favorable prices than prevailing today. I have almost zero interest in adding to bond positions at current prices.

1. Floating Rate Securities with Minimum Guarantees: The first group of securities, which I started to purchase during the Near Depression period, have the capability to work in both the deflation and inflation scenarios. I say "capability" to emphasize that many of these securities are non-cumulative floating rate equity preferred stocks issued mostly by financial institutions. In short, the security could work in both scenarios assuming the issuer continues to pay the dividends. Some of these securities are synthetic floaters tied to both junior and senior bonds. One disadvantage of the synthetic floaters is that they have a maximum yield which would make them work less well in a hyper inflationary environment with skyrocketing short term rates then the equity preferred floaters with no maximum yield level. I discuss these securities in greater detail in posts discussing their purchase: Floaters: Links in One Post Introductory discussions are provided in Advantages and Disadvantages of Equity Preferred Floating Rate Securities and Synthetic Floaters.

Both of these security types pay the greater of a guarantee, usually somewhere in the 3% to 4% range, or some percentage above a short term rate such as the 3 month treasury bill or the 3 month LIBOR rate. Historically, the 3 month LIBOR rate would be higher than the 3 month treasury bill. I would therefore expect a .75% over 3 month LIBOR to be a better float than .75% over the 3 month treasury bill. These securities were very appealing during the Dark Period, when the market crushed their prices, which enhanced both their deflation and inflation protection to me.

A simple way to understand the effect of purchasing these securities at a large discount is my purchase of METPRA at $7 and then again at $12.5. (the decline in a similar security, AEB, was even more extreme) This equity preferred floater was bought at the $12.5 price in April 2009, Added To METPRA, and earlier in the Dark Period at the $7 price. Par value is $25. METPRA pays the greater of 4% or 1% above the 3 month LIBOR rate. If I bought METPRA at $25, the 4 % guarantee is worth 4%. Buying the security at 1/2 of par value results in a guaranteed yield of 8% (assuming MET LIFE pays the dividend!). The $7 price results in a minimum yield of 14.29% (4% x. $25 par value=$1 per share per year dividend by a cost of $7 per share=14.29%). A purchaser at last Friday's close of $23.27 would have only a 4.3% minimum yield. So the guaranteed minimum of 4% applied to the $25 par value is the deflation protection. The inflation protection is the LIBOR float which is activated when the 3 month LIBOR rate exceeds 3% during the relevant computation period for METPRA. This could be due to a number of factors, most likely a rise in the benchmarks rates set by central banks in an effort to control inflationary pressures which would be smashing the value of fixed coupon bonds. LIBOR Rates History (Historical)

For the METPRA bought at $12.5, a 6% 3 month LIBOR rate during the relevant computation period would result in a 14% yield for those shares. (6% + 1% spread=7% rate x. $25 par value=$1.75 per share per year dividend by the $12.5 cost=14% or 8% over the 6% LIBOR rate). This is the inflation protection. Inflation or Deflation: Bond Alternatives/

2. Long Term Investment Grade Corporate Bonds: I have bought a large of these securities since September 2008, mostly in trust certificate legal form. A trust certificate represents an undivided interest in the asset of a trust, administered by an independent trustee, and that asset will be a bond. Trust Certificate Links in One Post

I also own some Trust Preferred Securities which are in essence junior bonds, though many of those are rated below investment grade as a result of the financial crisis. The last category are baby bonds or mini bonds traded on the stock exchange. Exchange Traded Bonds. Almost all of these securities have enjoyed huge rallies in recent months, as investors bid up prices trying to secure some kind of yield.

For purposes of my strategy, I divide those bonds into two general categories: those bought at prices to yield more than 10% (no longer available for new purchases) and those yielding less than 8%. I have a few that are in between but most are in one or the other category.

For those with yields over 10% at my purchase cost, I intend to hold them even if inflation becomes a problem. The income stream now is another reason to keep them. Many of those purchases are yielding more than 15% and the bonds are investment grade bought during the height of the financial crisis. (some REIT equity preferred stocks also fall into this category with one yielding 70% per annum at my purchase cost of $2.9, as does several but not all of the ING and AEG hybrid purchases: Buy of AEH at $4.63 in IRA; Bought 50 AEF at $16.82, Buy of 50 INZ at 7.82- all still owned)

The other category contains a number of bonds purchased with less than 8% yields over the past year as I cope and adapt to the continuing Fed Jihad. We must all do our part to help the Masters of Disaster get back on their feet quickly, which they have already done, and start earnings tens of millions for being doofuses and the most overpaid persons in the history of mankind and the universe in all of its dimensions. I would postulate that there must be a very clear advantage to looking and/or acting like you know what you doing.

I am trading those bonds some, clipping some interest payments and attempting to lower my average cost by trimming on pops and hopefully buying back on dips. Many of the trades are in 50 share lots. (e.g. Sold 50 REPRB at 21.9 & discussion in Item # 4 CPP) If interest rates start to spike I am likely to start dumping most of those bonds. The risk of loss is just too great in a rapidly rising interest rate environment. Some of the bonds that fall into this category include the following: Bought PJL at 24.42; Bought 100 MJV at $24.8; Bought 100 of the TC JBI at $25.1; Bought 50 JBI at 24.81; Added 50 PJI at 20.17; Bought 50 KRBPRE at 24.62 in Roth IRA; Bought 50 Shares of FPCPRA at 25; Bought 50 PJS at 23.73; Sold 50 of 150 DKK (all DKK shares); Added 50 KTX at 25; /Bought 100 AMPPRA at $24.75; Bought in ROTH 50 VNOD at 24.86; /BOUGHT 50 VNOD AT 24.85 in Taxable Account; Sold 50 of the 150 of VNOD at 25.54; Bought 100 UZV at $24.42; Bought 50 AFE at 22.87; Bought 50 AFE at 23.17; Bought 100 TDA at 25.22; Bought 50 NPBCO at 23.09/; Bought 50 of the TC PZB at 19.85; Add 50 PYS at 19.59; Bought 100 of the TC DKF at 25.87; and Bought 50 TP SBIBN at 23.2. I have already started to pare some of these positions such as AMPPRA, FPCPRA and DKK.

There is a lot of interest rate risk baked into a bond with such a distant maturity. {Item # 1 Impact of Rising Rates on Bond Prices & Item # 2 Interest Rate Risks- Bonds, see also SIFMA's discussion at Rising Rates and Your Investments)

Besides trading in and out, I will use one or more triggers to sell these positions, such as a rise in the LIBOR to over 1.5% or the 10 year treasury piercing a 4% yield with gusto. I am not adverse to buying the 10 year non-inflation protected treasury note, just not at 3% or even 4%, or 5% for that matter. At 6%+, I may start to nibble. (historical weekly 10 year CMT treasury since 1962 www.federalreserve)

On the other hand, if the Japan type scenario unfolds, these bonds referenced above will continue to do well (assuming no serious credit risk issue which is always a concern with corporate bonds!) and provide me with a good stream of interest income compared to the alternatives, some of which are summarized at the beginning of this post.

3. Use of Bond CEFs and Some Bond ETFs: I am simply not able to buy a bond fund such as BND yielding 3%. This is just not going to happen. Instead, I have recently added some bond CEFs selling at a discount to par value as an alternative, but many of those have rallied since my purchase and I would consequently have no interest in them. The yields on these purchases (CEFs and ETFs) vary, but generally fall in the 5 to 9% range, depending on the fund. Added 100 BDF in the Roth at 17.1 Bought 100 BAB at 25.98 Preferred Stock ETFs: Bought 200 PGX at 13.53 Bough 50 NBB at 19.67 Bought 100 of the CEF HPI at 17.76 Bought 100 BTZ at 12.05 (current 200+ position in PSY is similar to BTZ); Added 50 of the CEF ERC at $14.14 (bringing position up to 250 shares); Added 400 ACG at 7.85 (later sold 200); Bought 200 ACG at $8.12 in Roth The purchase of 300 shares of both WIW and IMF, provide less of a current yield, but those CEFs do own inflation protected securities and consequently provide some dual protection with their current yields in the 3 1/2 to 4% range Bought 200 WIW at 12.29 Bought 300 of the CEF WIW at $11.94 Sold 200 WIW at $12.5 Bought 300 of the CEF IMF at 16.51

I prefer the bond ETFs and CEFs that pay monthly distributions. All of the the foregoing (PGX, NBB, HPI, ERC, BTZ, PSY, WIW and IMF) pay monthly except for BDF which was recently trimmed from 200 to 100 shares after it went ex dividend.

I also own three Vanguard bond mutual funds that I have been trimming (TIP, investment grade intermediate corporates, and intermediate tax free).

Again, there needs to be an exit strategy for bonds funds with no term dates.

4. Bond Funds With Term Dates: These investments are more of a compromise between deflation an inflation fears. By having a term date, when the fund liquidates, I receive a salve about inflation risk inherent in owning a bond fund. The deflation fear receives some solace due to locking in yields with fixed coupons. As previously discussed in great detail, these investments include bond CEFs and bond ETFs. The bond CEFs that I have owned have a 2024 term date whereas the bond ETFs will work only if the low inflation/deflation scenario persists only for a few more years. I have sold all of my shares in IGI when it started to sell at a premium to its NAV. { Bought 100 BSCH at 20.13; Item # 4 Bought 100 BSCE at $20.16; Item # 7 Claymore Introduces Term Corporate Bond ETFs Bought BSCF at$20.18; Bought 200 of the CEF GDO; Bought 100 of the CEF GDO at 18.6; Bought 70 of the CEF GDO in Regular IRA at 18.61 /Sold 100 IGI at 20.74 and Bought 100 GDO (GDO now at over 550 shares with dividends from 300 shares in taxable account used to buy more shares); Added 100 of the CEF IGI at 19.78; Bought 100 CEF IGI at $19.89; (see generally Managing Interest Rate Risk & Interest Rate Risks- Bonds } A similar approach is the use of the Canadian bond ETFs from Claymore, thought that product is different from the BulletShares.

5. Common Stocks with a History of Dividend Growth: In a number of recent posts, I have discussed the dividend growth strategy and the purchase of large cap dividend stocks that currently pay more than the 10 year treasury and who have a long history of raising dividends. (see e.g. Item # 6 Common Stock Dividend Growth vs. Long Term Investment Grade Bonds; BOUGHT VZ at $26.74; Bought 100 KMB at 60.58; (discussion of Cola Cola's dividend growth history in Item # 1: Barrons Recommendations and My Trades in The Barron's Columnists' Recommendations in 2009; Bought 50 COP at 48.75; discussion of Sysco dividend growth history at Item #1 SYSCO; discussions of Heinz dividend growth history at Item # 1 Heinz (HNZ) & Buy of HNZ at 31.67)

This strategy to deal with a low interest rate environment also involves the purchase of ETFs, along with some buying and selling of those ETFs. Bought 100 OEF at 49.61 & Sold 102 VV at 49.43 Sold 101 VTI at 55.21 and Added 100 OEF at 49.11; Bought 100 of the ETF DTN at 42.45; Bought 100 DHS at 35.32; Bought ETF DTD at 41.7. In a deflation or long term low inflation scenario, however, I would expect the rate of dividend increases to slow down or stagnant even for the largest, most financially secure corporations with stable businesses.

While large money city banks have proven to be an unreliable source of steady dividend income, I have bought a large number of smaller banks in my regional bank strategy that have either maintained or increased their dividends during the Near Depression period.

Another source of dividend income would be electric utilities and I own several of them. Their dividend increases will generally be far more modest than consumer staple stocks like Coca Cola and Sysco. But, many of them do provide over 5% current yields at today's prices which is more than 2% greater than the 10 year treasury bond. My two core holdings are Duke (DUK) and Consolidated Edison (ED), where I will occasionally add to positions and use the dividends to buy additional shares. I also currently have positions in FE, POM, and PNW. Bought 100 POM shares at 15.96 Sold 50 FE of 150 at 38.77 Pared PNW at 39.25

Another point about stocks vs. bonds is made in this WSJ article. A graph in that article compares the gap between the earnings yield from the S & P 500 versus the 10 year treasury. The advantage for stocks is accelerating.

Lastly, I have not yet broke down and bought many bonds yielding less than 7%. It is conceivable that I may nibble some in this sub-optimal category, as I recently did with USBPRF. But, given the balance of the yield and interest rate risk, I will be trading quickly in and out of those issues with small positions. Sold 50 USBPRF at 23.94 I would add some comments about that USBPRF. It was yielding less than 7% when I bought it and it is a TP from a bank maturing in 24 years, a ton of interest rate risk and some credit risk. While I regard U S Bank more highly than a Citigroup or Bank of America, it is still a bank and that security is still a TP, a deeply subordinated piece of paper with liberal deferral rights. Last Friday, I could have added a senior bond (no deferrals permitted) to an existing position, with a higher rating and a shorter maturity, that yielded 1/2% more than USBPRF. So comparatively speaking, I have several better alternatives for my capital.

But, any long bond bought now is nothing more or less than a trade, and I will not risk much capital given what I perceive to be the present balance between yield and interest rate risks.

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