Flexible income strategies — Avoiding side effects from the Fed’s medicine

David King, CFA, Senior Portfolio Manager | August 11, 2014

  • In today’s low interest rate environment, investors with cash on hand and a limited appetite for risk aren’t having an easy time growing their wealth.
  • The Fed’s strong influence throughout the government and corporate bond markets makes it hard to find attractive fixed-income instruments of low or moderate risk.
  • To increase an investor’s chances of success, an investment strategy needs the flexibility to look beyond the most visible asset classes with the most homogeneity and highest correlations.

The U.S. economy went into recession in 2008, and it looked serious. As our fiscal deficit piled up, the political appetite for high government spending waned, leaving monetary policy as the primary available weapon to prevent recession from becoming depression. By mid-2011, Treasury bond yields had reached all-time lows. This strong monetary medicine now seems to be working. Many economic statistics have rebounded to peak levels, while some forward-looking ones, like major stock market indices, have hit new highs.

However, with strong medicine there can be side effects. Persistently low interest rates have put savers under attack. Perhaps this wasn’t the Fed’s intent, but the good people with cash on hand and a limited appetite for risk aren’t having an easy time growing their wealth with 5-year Treasury Notes yielding well under 2%.

Free markets have a way of trying to resolve economic imbalances, such as the side effect of current Fed policy. As you read this article, assume that investment bankers all over the world are trying to devise new securities that will raise money for worthwhile business projects while providing an income stream to yield-starved financial investors. This is good news, but how can an individual investor participate in this problem-solving innovativeness?

In managing strategies with a flexible income objective, we notice the Fed’s strong influence throughout the government and corporate bond markets, and the associated difficulty in finding attractive fixed-income instruments of low or moderate risk. Higher bond prices have also driven broad stock indices up, although there remain some common stocks with relatively appealing income profiles. It is on the margin of financial markets, however, where economic forces are connecting business opportunities with income seekers. Investors with the inherent flexibility to consider new securities can still find interesting income opportunities such as the following:

1. Corporate inversions
The cynical view of American companies merging with entities in lower tax domiciles is that it’s all about reported earnings, and these mergers are a lot of work (or risk) for a one-time pop in a stock’s price. Not necessarily. Another (bad) feature of U.S. corporate tax policy is its tendency to trap earnings overseas in the form of excessive, low-earning cash balances. Becoming a non-U.S. corporation can liberate these cash hoards and create a situation where moderate earnings growth, combined with a moderately-rising dividend payout ratio, creates an excellent dividend growth profile for years to come. We believe this thesis is at play in at least one recently announced large merger in the healthcare sector.

2. YieldCos
This title sounds gimmicky, and some companies yet to be born into this genre probably will be. However, the first few companies of this kind — essentially tax-efficient structures for holding and accumulating mature, cash-generative businesses — have been well-received by the market and generated good dividend growth at the outset. We see other corporations copying elements of the YieldCo strategy. These companies have yet to be fully noticed by the market, but may have similar potential returns to those of the early YieldCos.

3. Convertible bonds into private companies
Average investors would certainly like a shot at the financial success of prosperous private equity capitalists. The newly invented idea of development-stage companies issuing convertible bonds with high profit potential in a future IPO is an innovation we are following closely. One issue of this kind, done by a company whose CEO has a proven track record of value creation in his industry, has already performed well in our portfolios.

The moral of the story? Just when you believe that powerful factors beyond your control — like the Fed — stand between you and achieving reasonable financial goals, market forces make the effort to come to your aid. To increase your chances of being rescued by these market forces, your investment strategy needs the flexibility to look beyond the most visible asset classes with the most homogeneity and highest correlations. Does the Fed care about the expected returns on U.S. Treasury bonds? Yes. And at the moment, their plan calls for those returns to be low! If the Fed has any thoughts about the total return potential of equities in newly merged Irish corporations, they are keeping quiet. Quiet enough that investors in these stocks might just benefit from growing dividends and capital appreciation? We think so.

 

David King

CFA, Senior Portfolio Manager
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