Bonds & Interest Rates

Bonds & the Great Secular Shift

Posted by Mark Jasayko, CFA, Portfolio Manager

on Wednesday, 8 January 2014 17:37

McIver Wealth Management Consulting Group / Richardson GMP Limited
10 year Treasury yields on both sides of the Great Secular Shift

This morning I read a couple of articles from interest rate strategists making a case for buying government bonds. One of them saw the yield on the U.S. 10 year Treasury bond falling from where it is now at 2.98% down to 2.10% at some point this year.

However, those views are swimming against the tide of reality. Since July 2012, 18 months ago, bonds have been moving in a direction that is different from the direction they were moving in for the previous three decades. From the beginning of the 1980’s to July 2012, bonds were in a Secular Bull Market as yields consistently fell during that stretch with a few minor interruptions. Since July 2012, yields have been rising.

The cycles between Secular Bull Markets and Secular Bear Markets in bonds are prominent during financial market history and tend to shift once in a generation (about once every 25 to 30 years). When the yield on the U.S. 10 year Treasury bond hit 1.39% in late July 2012, that was just such a shift. As the chart above shows, the bond market action on both sides of the shift are distinguishable.

One thing that can temporarily disrupt the new Secular Bear Market in bonds is a rush to the relative safety of the U.S. dollar and U.S. government bonds in response to some global financial cataclysmic event. However, that is not what these strategists mentioned when they talked about the potential for rates to fall this year.

That said, even the gutsiest bond bulls would hesitate to state that we will see the benchmark yield back to its generational low of 1.39% in late July 2012. In fact, it is likely that we will not see the benchmark rate back at that level in the next half century. Talk about long-term! But, Secular trends in the bond market are long-term.

The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Limited or its affiliates. Assumptions, opinions and estimates constitute the author’s judgment as of the date of this material and are subject to change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results. 

Richardson GMP Limited, Member Canadian Investor Protection Fund.

Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.

Southern Company (SO) is a large regional utility based in the southeast United States. The company has over four million customers and sports a $36 billion market cap as of this writing. The common stock also pays a very nice dividend but in this article, we’ll take a look at another way to take advantage of SO’s strength and stability, the Alabama Power 6.45% Series Non-Cumulative Preference Stock (ALBMP), and to see if it is right for your income portfolio.

ALBMP is a traditional preferred stock which means it has no stated maturity date and pays regular, quarterly dividends. The stock was issued at $25 per share and pays an annualized dividend of $1.6125, good for a 6.45% coupon yield. As shares are trading at a small premium to that price, $25.95 as of this writing, the current yield is actually a bit lower at 6.2%. However, that is still a very strong yield and particularly from a stable cash machine like SO.

Beginning in 2017 ALBMP is callable by SO for the $25 issue price plus any declared but unpaid dividends. This means that if you were to initiate a position today and shares were subsequently called, you’d be subject to a capital loss of 95 cents per share 3.5 years from now. While that is undesirable it is also a very small potential capital loss. While I don’t normally recommend buying preferreds at a premium, this particular issue still warrants a look because of its strong yield in relation to the safety of the payer. SO is about as safe as it gets in terms of repayment risk so you aren’t going to see its preferreds in the 8%+ range unless interest rates spike out of control.

ALBMP is also eligible for the preferential dividend tax treatment, meaning that holders of ALBMP in a taxable account will see an appreciable increase in the after-tax yield of this security in relation to a comparable issue that is ineligible for the preferential tax treatment. This is a sizable positive as it means holders in a taxable account would have an after-tax yield of 5.3% versus 4.3%, assuming 15% and 30% tax rates, respectively. That is a huge difference and thus, the preferential tax treatment makes ALBMP all the more attractive.

ALBMP, like any other security, has risks associated with owning it. Principal among them is interest rate risk. If we see interest rates spike, ALBMP will trade down, all else equal. This means that holders will be subject to capital losses. Unfortunately this is a hazard of owning any income producing security and ALBMP is no exception. However, I believe ALBMP will stand up to interest rate spikes somewhat better than less favorable issues from companies with higher repayment risks. The reason is because the dividend on ALBMP is about as safe as you can get given SO’s financial strength and proven ability to produce cash. However, ALBMP is not immune to interest rates and as such, will likely move down in price if interest rates spike.

Additionally, ALBMP is non-cumulative, meaning that if SO were to miss dividend payments, it is under no obligation to make them up to holders of ALBMP. Thus, SO could potentially stop paying dividends on ALBMP and never restart if it so chose. Of course, reality is more complicated than that as SO is a seasoned security issuer and if it suddenly chose to stop paying on its existing obligations, new security issues would undoubtedly carry much higher coupons in the future. As SO relies on the capital markets for funding that seems a very distant possibility to me. However, just be aware the risk exists due to ALBMP being a non-cumulative issue.

Overall, while ALBMP doesn’t have the highest yield in the preferred security universe, it does offer stability and safety from a very high quality payer with stable cash flows. If you can look past the non-cumulative nature of the issue, the preferential dividend tax treatment combined with the nice yield of more than 6% could be a decent addition to your income portfolio. Keep in mind that buying a preferred at a premium brings with it risk of capital losses should the issue be called but given the other positives of ALBMP, the premium is a small price to pay.

Bernanke’s Bizarro World

Posted by Mark Jasayko, CFA, Portfolio Manager

on Thursday, 2 January 2014 22:28

McIver Wealth Management Consulting Group / Richardson GMP Limited
The Current Yield on Rwandan Govt 10-year Debt is only 7.4%

I have talked from time to time about how the policies of the U.S. Federal Reserve have ignited a “Dash For Trash” as investors chase anything that looks like it has an above average yield to compensate for the low yields on U.S. government and high-grade corporate debt. REITs, high-yield bonds, companies with high dividend payout ratios, and bonds issues by suspect governments around the world have benefitted.

One of the examples that I have focused on are the 10-year bonds issued by the Government of Rwanda back in April. They were initially priced to yield under 7% and investors snapped them up.   I found it surprising that an agrarian economy dependent upon foreign aid in a region that is only a decade and a half removed from eye-popping mass carnage and ethnic cleansing was able to securing financing at these rates.

Well, Rwanda is back in the news. Adversaries of the current leadership have been threatened and some are showing up dead. ( http://www.usatoday.com/story/news/world/2014/01/02/rwanda-spy-chief-dead/4287373/ ) All the while, the current yield on the Rwandan 10-year bond is still at 7.4%, thanks in part to the policies of the Fed.

The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Limited or its affiliates. Assumptions, opinions and estimates constitute the author’s judgment as of the date of this material and are subject to change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results. 

Richardson GMP Limited, Member Canadian Investor Protection Fund.

Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.

WASHINGTON (MarketWatch) – The Institute for Supply Management’s index of U.S. manufacturing conditions is expected to fall slightly in December but remain on the stronger side, according to economists polled by MarketWatch … full article

A Chinese manufacturing gauge slipped to a four-month low in December, underscoring challenges for President Xi Jinping as he tries to sustain economic momentum while rolling out reforms.

The Purchasing Managers’ Index was at 51, the National Bureau of Statistics and China’s logistics federation said yesterday in Beijing. That was less than the median 51.2 estimate in a Bloomberg News survey of 29 economists and November’s 51.4. A separate manufacturing index is due to be released today by HSBC Holdings Plc and Markit Economics.