How to get 7% Income (Barrons)

Barron's Cover | MONDAY, NOVEMBER 21, 2011 How to Get Safe Annual Payouts of 7%
By KAREN HUBE |
Despite rock-bottom interest rates, you can still earn investment income of 7%-plus per year. How to keep money flowing during retirement.
Not so long ago, you could build a reliable portfolio of income-producing investments with just a few simple steps: Buy some Treasuries, some corporate bonds and some munis, and then watch the money roll in. That kind of investing is a long-lost luxury. Yields on core bond holdings have been slim for three years in a row. And while 10-year Treasury yields, at 2%, are higher than they were a year ago, you aren't going to do much better any time soon. The Federal Reserve says it is going to hold rates low until mid-2013. Bottom line: Traditional fixed-income portfolios don't work anymore, and "if retirement investors don't start thinking differently, they're going to run out of money," says Erin Botsford, CEO of the Botsford Group, a Frisco, Texas-based financial advisory firm.

Thinking differently, however, raises new challenges for retirement. Yields of 5% and 7% are attainable, but you have to look globally and across asset classes that may seem unfamiliar, such as emerging-market bonds, global infrastructure stocks, master limited partnerships and mortgage real-estate investment trusts.

The hunt for higher yields requires vigilance. Some risks are obvious: Greek sovereign debt, now yielding over 100%, clearly is no way to finance a leisurely retirement. But more often risk is difficult to spot.

Take the Pimco High Income closed-end fund (ticker: PHK). The fund not only has a highly regarded brand name and widely respected manager, Bill Gross, but also an enticing 11.7% yield.

"But if you look at funds not to buy, this is the poster child," says Maury Fertig, chief investment officer at Relative Value Partners in Northbrook, Ill., who points out that the fund trades at a 67% premium to its net asset value. Investors who buy into the fund are paying far too much for a yield that isn't guaranteed, he says.

Then there's the risk of inaction. If you stick with the traditional income investments, you will be losing money in inflation-adjusted terms.

The 10-year Treasury, with its 2% yield, is a clear loser with today's 3%-plus inflation. Ditto for certificates of deposit and money-market funds.

"You may be preserving your principal, but you aren't going to keep up with inflation," says Malcolm Makin, an advisor at Professional Planning Group in Westerly, R.I. For example, you have to lock your money up in a CD for five years just to get an average 1.5% pretax return. "That isn't going to seem so safe in retrospect at age 70 or 75, when your money has dried up," Makin says.

To increase yield and balance the risks, income portfolios must be cobbled together with a number of investments, ranging from Treasuries to junk bonds. Some—those with the highest credit risk or illiquidity, for example—should make up 2% or less of a portfolio. But even at those levels they can add income and help diversify your holdings.

Here are 11 choices with attractive yields. If you haven't looked at these kinds of investments before, now is an excellent time to start.


Closed-End Corporate-Bond Funds

Regular corporate-bond mutual funds can give you an edge over Treasuries, with yields around 3%, but you can get much more from closed-end bond funds, which trade like stocks.

"There are funds available at substantial discounts to net asset value, and the fact that these funds employ leverage, and their cost of borrowing is very low, can provide additional yield," says Relative Value's Fertig, who recommends these as a piece of a diversified income portfolio.




Fertig likes AllianceBernstein Income fund (ACG), which specializes in investment-grade corporates, Treasuries and agency bonds—debt issued by the likes of Fannie Mae and Freddie Mac. The yield: 6%. "It's trading at a 10.7% discount to its net asset value," he points out.

BlackRock Credit Allocation Income Trust fund (BTZ) is another good prospect, trading at a 13% discount and with a yield of 7.7%. But it is a little more risky, with many AA-rated and BBB-rated bonds—still investment grade, but just barely.


Municipal Bonds

Municipal bonds offer a rare opportunity for investors because they yield more than their taxable-bond counterparts and provide tax breaks to boot. For individuals, leveraged closed-end muni funds are great choices. They are riskier because of their leverage, but that's limited by the Fed's pledge to keep rates low. With tax-free yields above 6%—and many muni funds selling at a discount to NAV—that's equivalent to a taxable yield over 9% for somebody in the 35% tax bracket. Two that look good are BlackRock Municipal Income Quality Trust (BAF), with a 6.3% yield, and Neuberger Berman Intermediate Municipal (NBH), yielding 5.6%. Those yields equate to 9.7% and 8.6%, respectively, for taxpayers in the top bracket.

Less risky, because it uses no leverage, is the Vanguard High Yield Tax Exempt fund (VWAHX), which yields 4.4%, equivalent to 6.8% for high earners.

High-Yield Bonds

Bonds that don't qualify as investment- grade—rated BB or lower—clearly come with more risk, "but you can pick up substantial yield if you look at BB ratings primarily," rather than lower-rated bonds, says Michael Persinski, managing director of U.S. Investment for Citi Private Bank. Yields on these issues are around 7.3%.

Investors have been flocking to high-yield, or junk, bonds lately because the difference between their yields and those of Treasuries widened significantly since April. The current spread is 7.2 percentage points. Valuations are still attractive, says Jamie Kramer, head of thematic advisory at J.P. Morgan. The market is pricing in default rates of around 8%, yet the current rate is 2%.

The best strategy for investing in junk bonds is through a fund or ETF, because they are broadly diversified and have low transaction costs. Eaton Vance Income Fund of Boston (EVIBX) yields 7.9%, and iShares iBoxx $ High Yield Corporate ETF (HYG) yields 7.5%


Emerging-Market Government Bonds

Compared with European sovereign debt, emerging-market government bonds look like safe bets. And with an average yield of 6%, they pay three times that of U.S. Treasuries. Once viewed as high risk, these bonds have become much sturdier amid the rapid growth of developing-world economies.

Emerging-market bond funds can minimize currency risk by using hedging strategies; or you can bet on currencies as well as yields. Funds with currency exposure can give added return when the dollar falls.

While emerging-market currencies are expected to strengthen over the long term, that is no steady trend. Lately, those currencies have declined about 20% relative to the dollar, making currency-exposed funds more volatile, says Michael Herbst, associate director of fund analysis at Morningstar. For currency diversification, he likes Pimco Emerging Local Bond (PELAX), yielding 6.8%. A solid fund that hedges currency risk is Fidelity New Markets Income (FNMIX), with a 5.4% yield.

If you want to leave it up to a manager whether or not to hedge currency risk, consider T. Rowe Price Emerging Markets Bond fund (PREMX), yielding 6.8%.

Dividend-Paying Stocks

Your grandfather may have scoffed at today's dividend yields, but don't pass them by. The average yield on Standard & Poor's 500 stocks that pay dividends, at 2.5%, is well below the historic average of 5.8%. But the last time the index had a higher yield than 10-year Treasuries was 1958. That means investors have an opportunity to capture capital appreciation as well as Treasury-beating yields. And payouts are likely to get stronger as the economy continues to recover, says Howard Silverblatt, senior index analyst at S&P.

By sector, telecom companies have the highest yields, at 6%, followed by utilities at 4.2% and health care at 3%.

For investors who like these yields but are concerned about the risk of investing in stocks, look for companies that have raised their dividends for the past 10 years and aren't straining to pay them, Silverblatt says.

He suggests making sure that companies' earnings are at least twice their payouts. Among those that make the cut: Chevron (CVX), which yields 3%; Johnson & Johnson (JNJ), 3.5%; and Northeast Utilities (NU), 3.2%.




Global Infrastructure Stocks

Companies that own and operate infrastructure such as sea ports, toll roads and utility lines not only are good for yield—expect about 5% from a basket of the stocks—but also tend to perform better than the market in downturns.

"These companies are rich on physical assets, and a lot of them have monopolies. For example, if a company builds a toll road, someone isn't going to build a toll road right next to it," says Mike Finnegan, chief investment officer of Principal Funds and manager of the Principal Global Diversified Income fund.

Among his funds' holdings are PPL (PPL), a utility with operations in the U.S. and Britain, and BCE (BCE), a Quebec-based telecom provider.


Master Limited Partnerships

Advisors like energy-related master limited partnerships not only for their solid dividend yields—often 6% or more—but because they are relatively stable investments and good for diversification.

MLPs are publicly traded limited partnerships. Because of their organizational structure, they don't pay corporate taxes and can pass much of their profits on to their investors. The safest bet is to stick with energy MLPs that own and operate oil and natural-gas pipelines, such as Kinder Morgan Energy Partners (KMP), yielding 6%, and Mark West Energy Partners (MWE), yielding 5.3%. These partnerships aren't closely correlated to stocks and aren't affected by the rise and fall in energy prices, because they collect fees for transporting oil and gas, no matter what happens to the prices.


REITs

Real-estate investment trusts have had strong returns in recent years, and right now they are paying respectable yields.

The apartment sector has been particularly strong, the result of millions of cash-strapped families deciding to rent instead of buy. David Campbell, a principal at Bingham Osborn & Scarborough in San Francisco, recommends two apartment REITs: Camden Properties Trust (CPT), yielding 3.3%, and AvalonBay Communities (AVB), yielding 2.9%.

Fidelity Real Estate Income fund (FRIFX), with a yield of 5.1%, and Vanguard REIT ETF (VNQ), 3.4%, each will give you a diversified basket of REITs.

But when it comes to income, mortgage REITs that invest in mortgage-backed securities issued by Fannie Mae and Freddie Mac may be your best bet. Since their portfolios are guaranteed by the federal government, there's very little credit risk. So the main risk is that the Fed raises interest rates, and it has told us that won't happen before 2013. Annaly Capital Management (NLY) is the biggest in the bunch, with $113 billion in assets and a whopping yield of 14.8%.


Equipment Leasing

When a company leases a piece of heavy equipment, such as an oil tanker or a railroad car, income investors stand to benefit.

Here's how: Independent firms buy up large quantities of leases with investors' pooled assets, "and then investors pick up the income stream from these leases," she says. Current yields are 7% to 8%.

Investors take on the risk of the leases, but Botsford thinks this risk is small.

"We're talking about low-tech equipment that doesn't get obsolete, and 20-year lease cycles," Botsford says. Companies leasing the equipment typically have long track records of making their lease payments. The default rate is minimal, and typically there are about 50 leases in an investment pool.

To participate you have to work through brokers or asset managers, whose firms ooften have access to specific pools, such as those managed by Icon Investments and Cyprus Financial.

The caveat: These lock up investors' money for five to seven years, so Botsford recommends keeping the allocation to about 2% of your portfolio.


Immediate Fixed Annuities

Major stock-market declines and wild volatility have increased the appeal of low-cost annuities. One of the most widely recommended types by advisors is the simplest kind: an immediate fixed annuity. You fund this annuity with a lump sum, and it immediately starts paying out a guaranteed income for life—or a term you specify.

Investors get a higher monthly payment than they could if they tried to create their own income stream from their investments. That's because of annuities' so-called "mortality credit," which is the benefit resulting from pooled assets of many investors. "Some investors are going to die early, and since the insurance company isn't going to have to make their payments, they use them to benefit those still living," says Steve Horan, head of private wealth at the CFA Institute.

With yields of 6% to 7%, a 65-year-old man in good health can turn a $200,000 annuity into monthly payments of $1,100 for life.


Longevity Insurance

If you knew you were going to live until, say, age 85, planning an income stream would be a lot easier. But what worries many retirees is their longevity risk—the chance that they will live a lot longer than they expect.

That's why insurers have recently come out with a new kind of annuity called longevity insurance. This is a kind of deferred annuity that you buy early on to secure an annuity stream five to 20 years down the line. At age 65, you can buy one to begin paying at age 85. "This fixes the time-horizon problem and makes planning a lot easier," Horan says. "These are cost efficient, and they transfer the longevity risk to the insurer," says Horan.

Solid longevity-insurance providers include New York Life Insurance and Metropolitan Life. Fees are embedded in the annuity calculation, but as with immediate fixed annuities, they are reasonable. Through NY Life, a 60-year-old healthy man who buys a $100,000 longevity insurance contract today can secure a $2,916-per-month annuity that begins at age 80 and pays out for life.

In all, our 11 investments offer solid income at a time when any income is hard to come by. In other words, yes, you can still retire comfortably.

.E-mail: editors@barrons.com

How to Make Money from Inflation (WSJ)

WEEKEND INVESTOR
FEBRUARY 5, 2011.How to Profit From Inflation
The Scourge of Rising Prices Hasn't Hit Home Yet, but the Underlying Signs Point to Trouble Ahead. Here's What You Should Do Now.

By BEN LEVISOHN and JANE J. KIM

Inflation,long a sleeping giant, is finally awakening. And that could present problems—along with opportunities—for investors.

A quick glance at the overall inflation numbers might suggest there is little reason to worry. The most recent U.S. Consumer Price Index was up just 1.5% over the past year. Not only was that lower than the historical average of about 3%, but it was uncomfortably low for Federal Reserve Chairman Ben Bernanke, who prefers to see inflation at about 2%.

What to Do Now
Sell
Cash and Bonds: Treasurys, long-term bonds
Stocks: Financials, utilities and consumer staples
Hard Assets: Gold, real estate

Buy
Cash and Bonds: Floating-rate funds, inflation-linked CDs
Stocks: Small-company value stocks
Hard Assets: Commodities, real-return funds

Yet it is a much different situation overseas, particularly in the developing world. In South Korea, the CPI rose at a 4.1% clip in January from a year earlier, higher than the 3.8% estimate. In Brazil, analysts expect prices to rise 5.6% this year, exceeding the central-bank target of 4.5%. China, meanwhile, has been boosting interest rates and raising bank capital requirements to keep inflation, which rose to 4.6% in December, in check.

"Emerging market economies are overheating," says Julia Coronado, chief economist for North America at BNP Paribas in New York. "They need to slow growth or inflation will become destabilizing."

Even some developed economies are seeing rising prices. Inflation in the U.K. surged to 3.7% in December, while the euro zone's rate climbed to 2.4% in January, the fastest rise since 2008.

Much of the uptick has been driven by commodity prices. During the past six months, oil has jumped 9%, copper has gained 36% and silver has shot up 56%. Agricultural products have soared as well: Cotton, wheat and soybeans have risen 100%, 24% and 42%, respectively. That's a problem because rising input prices "work their way down the food chain to CPI," says Alan Ruskin, global head of G-10 foreign-exchange strategy at Deutsche Bank.

Of course, the main inflation driver is usually wages—and that isn't a factor in the U.S., where high unemployment has kept a lid on pay for three years.

Yet there isn't a historical blueprint for the inflation scenario that seems to be unfolding now. Not only has the global economy changed drastically since the last big inflationary run during the 1970s, but the lingering effects of the recent debt crisis remain a wild card.

For investors, that means traditional inflation busters such as real estate and gold might not work as expected, while other strategies might perform better.

So how should you position your portfolio? The best approach, say advisers, is to tweak asset allocations rather than overhaul them. That involves dialing back on some kinds of bonds, stocks and commodities and increasing holdings of others. Here's a guide:

What to Sell
• Bonds. The price of a bond moves in the opposite direction of its yield. When inflation kicks up, interest rates usually move higher, pressuring bond prices. Even buy-and-hold investors get hurt, because higher inflation erodes the real value of the interest payments you receive and the principal you get back when the bond matures.

'There is no historical blueprint for the inflation scenario that seems to be unfolding now.'.The drop is usually most extreme in longer-dated bonds, because low yields are locked in for a longer period of time. So inflation-wary investors should shorten the maturities of their bonds, say advisers.

The safest bonds, especially Treasurys, are usually hardest hit, because those are the most influenced by changes in rates—unlike corporate bonds, whose prices also move based on credit quality. From September 1986 through September 1987, for example, as inflation moved higher, Treasurys dropped 1.2%.

It might even make sense to dial back on Treasury inflation-protected securities, whose principal and interest payments grow alongside the CPI. That's because investors already have flooded into TIPS, driving up prices and driving down the real, inflation-adjusted yields. A typical 10-year TIPS, for example, yields just 1.1% after inflation, compared with an average of more than 2% in recent years.

With so little cushion, long-term TIPS carry a higher risk of loss for investors who are forced to sell before the bonds mature. "Even if inflation is rising, you can still lose money," says Joseph Shatz, interest-rate strategist at Bank of America Merrill Lynch.

• Hard assets. Real estate may be a classic inflation hedge, but it seems likely to disappoint investors this time around. Even though rising inflation should put upward pressure on home prices, the twin forces of record-high foreclosures and consumers reducing their debt loads are expected to mute price gains for several years, says Milton Ezrati, senior economist at asset manager Lord Abbett. That's a far cry from the 1970s, when the median home price rose 43%, according to U.S. Census data.

Gold is another traditional inflation hedge that might be less effective now. With prices already having more than quadrupled over the past nine years, many strategists see substantial inflation already factored into the price.

Hot Commodities
Commodities that are more closely tied to industrial or food production seem better positioned now than gold, say advisers.

Historically, gold has moved with the money supply. During the last 30 years, the correlation has been about 69%, according to FactSet data. (A correlation of 100% means two indexes move in lockstep all the time; a correlation of minus-100% means they move in perfect opposition.) Based on the money supply alone, gold is priced 25% above where it should be, says Russ Koesterich, chief investment strategist at BlackRock Inc.'s iShares.

• Stocks. Equities can be a decent hedge against creeping inflation, because companies are better able to pass off costs to customers. But when input costs suddenly jump, profit margins take a hit.

At the same time, the higher interest rates that accompany inflation prompt investors to demand more profits for each dollar invested. As a result, price/earnings ratios tend to shrivel. Over the past 55 years, the average trailing P/E ratio of a stock in the Standard & Poor's 500-stock index has fallen to 16.95 during periods with inflation running between 3% and 5%, from 19.24 during periods with inflation of 1% to 3%, the most common inflation range since 1955, Mr. Koesterich says.

Sectors that are sensitive to interest rates, including financials, utility stocks and consumer staples, are especially vulnerable, say advisers.

What to Buy
• Cash and bank products. Money-market mutual funds are more attractive in inflationary environments because the funds invest in short-term securities that mature every 30 to 40 days, and therefore can pass through higher rates quickly. In an extreme example, money funds posted yields over 15% during the inflation-ravaged 1970s and early 1980s, says Pete Crane of Crane Data, which tracks the funds.

A growing number of inflation-linked savings products are cropping up as well. Incapital LLC, a Chicago investment bank, says it has seen a pickup recently in issuances of certificates of deposit designed for a rising-rate environment. Savers, for example, can invest in a 12-year CD whose rate starts at 3% then gradually steps up to 4.25% starting in 2015, and peaks at 5.5% starting at 2019 until the CD's maturity in 2023.

A caveat: If inflation eases and rates fall, investors could get burned, since the issuer may call the CDs and investors would lose out on the higher rates at maturity.

• Bonds. One way to reduce the impact of rising inflation on bond holdings is to build a bond ladder—buying bonds that mature in, say, two, four, six, eight and 10 years. As the shorter-term bonds mature, investors can reinvest the proceeds into longer-term bonds at higher rates.

"A bond ladder is best for someone who doesn't mind holding them for up to 10 years," says Jeff Feldman, an adviser in Rochester, N.Y.

Highly cautious investors might prefer the I Bond, a U.S. savings bond that earns interest based on a twice-yearly CPI adjustment. Although the current yield on I Bonds is only 0.74%, that yield is likely to move higher on May 1, the next time the rate is adjusted. I Bonds aren't as volatile as TIPS and appeal to conservative, buy-and-hold investors. The interest may also be tax-free for some families for education expenses.

More adventurous types might consider the inflation-protected government debt of other nations, which carry higher yields along with greater risks. The SPDR DB International Government Inflation-Protected Bond Fund is an international inflation-protected bond exchange-traded fund designed to do well if inflation in overseas countries moves higher. The fund returned about 6.8% in 2010 and 18.5% in 2009, according to Morningstar Inc.

• Bank-loan funds. Another way to exploit rising inflation is through mutual funds that buy adjustable-rate bank loans, many of which are used to finance leveraged corporate buyouts. So-called floating-rate funds are structured so that if interest rates rise, they collect more money. During periods of rising rates, floating-rate funds usually outperform other bond-fund categories. In 2003, for example, as investors anticipated higher interest rates and a stronger economy, bank-loan funds gained 10.4% while short-term bond funds gained 2.5%.

Now, amid expectations of rising inflation, investors are once again flocking to these funds, pouring in about $7.6 billion into loan funds in the fourth quarter of last year, according to Lipper Inc.—more than double the previous quarterly record set in 2007. The pace has accelerated this year, with investors putting in about $3.4 billion thus far.

After gaining almost 10% last year, the funds shouldn't be counted on for much price appreciation, says Craig Russ, who co-manages $22.7 billion of floating-rate investments across three floating-rate funds and other accounts at Eaton Vance Corp., including the Eaton Vance Floating Rate Fund. But the funds generate plenty of income, yielding about 4% to 5% now, according to Morningstar.

Price Increases
From Aug. 2, 2010 through Feb. 4, 2011:

Cotton: +100%
Silver: +50%
Soybeans: + 42%
Copper: +36%
Wheat: +24%
.


Be warned: Floating-rate funds can get creamed when investors fear the underlying loans are too risky. In 2008, for example, bank-loan funds lost 29.7%, although they zoomed 41.8% in 2009, according to Morningstar. What's more, banks are beginning to make riskier "covenant-light" loans that carry fewer stipulations for corporate borrowers—a sign of frothier trends in the market.

Given the potential for volatility, floating-rate funds are best viewed as a complement to—not a replacement for—investors' core bond holdings. Among Morningstar's picks in this category is the Fidelity Floating Rate High-Income Fund, among the more conservative in the category.

• Commodities. Materials that are more closely tied to industrial or food production seem better positioned now than gold, say advisers. The trick is to find the best investment vehicle.

The easiest way for small investors to gain exposure to most commodities is through exchange-traded funds, many of which use futures contracts. But such funds can be dangerous because they often face "contango"—when the price for a future delivery is higher than the current price. The result: The ETFs lose money as they buy new contracts, even when prices are rising.

The losses can be extreme. In 2009, for instance, while the price of natural gas rose 3.4%, the United States Natural Gas Fund lost 56.5% as a result of rolling over futures contracts.

Some firms have rolled out ETFs that aim to address the problem. One of Morningstar's picks is the U.S. Commodity Index Fund, run by U.S. Commodity Funds LLC. The portfolio buys the seven commodities that are most "backwardated"—the opposite of "contango," so rolling contracts should result in a profit—along with the seven commodities with the most price momentum.

"USCI provides an outlet for investors who want broad commodities exposure but don't want to worry about the daily dynamics," says Tim Strauts, a Morningstar analyst.

Other funds play inflation by holding many different assets to protect against rising prices no matter where they show up. The IQ Real Return ETF, launched in 2009 by IndexIQ, aims to provide a return equal to the CPI plus 2% to 3% over a two- to three-year period. To get there, it invests across a dozen or so inflation-sensitive assets—including currencies and commodities.

• Stocks. One corner of the market tends to do better when prices rise suddenly: small-company value stocks. "Because value and small stocks tend to be fairly highly [indebted] companies, inflation reduces their liabilities," says William Bernstein of Efficient Frontier Advisors LLC, an investment-advisory firm in Eastford, Conn.

From January 1965 through December 1980, for example, inflation averaged 6.6% a year. The Ibbotson Small-Cap Value Index posted average annual returns of 14.4%, according to Morningstar's Ibbotson Associates, double the S&P 500's 7.1% gain.

Morningstar's picks in the small-cap value fund category include Allianz NFJ Small Cap Value, Diamond Hill Small Cap, Perkins Small Cap Value and Schneider Small Cap Value. Just be warned: Small value stocks have had a good run recently, returning 134%, on average, since March 6, 2009.

In the end, the particulars of any inflation-fighting plan may not be as important as developing a plan in the first place.

"The real problem you run into with any kind of inflation hedges," says Jay Hutchins, a financial adviser in Lebanon, N.H., "is that if you don't already have them when inflation is around the corner, you've missed the boat."

Write to Ben Levisohn at ben.levisohn@wsj.com and Jane J. Kim at jane.kim@wsj.com

Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved

GM Bondholders Hanging Tight - NY Times Dealbook

May 22, 2009, 8:03 am

G.M. and Creditors Face White-Knuckle Weekend
The long weekend will be anything but a holiday for General Motors, the giant automaker struggling to stay out of bankruptcy protection.

The company reached a deal Thursday with its union on concessions, but it is now racing the clock to persuade its bondholders to eliminate $27 billion in debt and avoid a bankruptcy filing.

G.M. has until Tuesday to persuade thousands of bondholders to agree to swap their debt for equity, which would fulfill its last significant requirement for restructuring ordered by President Obama. There appears to be little chance that the required 90 percent of bondholders will agree to its terms, making the prospect of bankruptcy increasingly likely for G.M., The New York Times’s Bill Vlasic reported.
Analysts said that the United Automobile Workers’ deal with G.M., which followed similar concessions to Chrysler, will increase pressure on bondholders to accept the company’s offer.

“I think there’s a shot it will succeed, but a very small one,” David Cole, chairman of the Center for Automotive Research in Ann Arbor, Mich., told The Times.
A coalition of small bondholders protested the terms of G.M.’s offer in Washington on Thursday. Larger, institutional bondholders have also opposed the deal, which calls for them to receive 225 shares of G.M. stock in exchange for each $1,000 worth of debt.
A G.M. spokesman, Greg Martin, told The Times the company had made no decision on whether to extend the exchange offer beyond the Tuesday deadline.
“We have made it clear that our viability requires us to take these actions to restructure our operations and reduce the liabilities and debt on our balance sheet,” Mr. Martin said.

G.M., which is subsisting on $15.4 billion in government loans, has until June 1 to meet the broad criteria for restructuring spelled out by a special presidential auto task force.

Under a plan announced last month, the Treasury Department would control at least 50 percent of the stock in a restructured G.M. A health care trust for union retirees would have about 39 percent, with bondholders getting 10 percent and current shareholders the remaining 1 percent.

Advisers to a committee of G.M.’s biggest bondholders, representing about 20 percent of the $27 billion in bond debt, have repeatedly criticized the plan as unfair and designed to fail. They have also accused the government of seeking to use them as scapegoats for a potential bankruptcy filing. Under their own proposal, G.M. bondholders would own 58 percent of the reorganized carmaker. These advisers have said that they are willing to negotiate with the company and the government but have made no headway thus far.
As for the U.A.W., details of its agreement with G.M. are being withheld pending a ratification vote by 61,000 union workers in the United States, which is expected to take place next week. But the deal does include financing the retiree trust. People close to the talks said the union agreed to allow G.M. to finance half of its future retiree health care costs — estimated at $20 billion — with company stock.

The Obama administration hailed the agreement as an important step in G.M.’s comeback plan.

The U.A.W.’s president, Ron Gettelfinger, had been critical of G.M.’s plans to cut an additional 21,000 union jobs, as well as increase its imports of vehicles made in China, South Korea and Mexico.

Whether those job cuts are addressed in the agreement is still unclear. But by agreeing to amend its contract, the union can rightfully say it has completed the task laid out for it by the Treasury Department.

Since G.M. first appealed for government assistance last fall, the U.A.W. has made several modifications to its 2007 contract, including eliminating a program that guarantees paychecks to laid-off workers. By completing its agreement on health care, the union has heeded Mr. Obama’s call for shared sacrifice among all G.M. stakeholders to fix the troubled company.

“The union has worked very well to create the right optics and to be in sync with the message the White House has put out there,” John Casesa, a principal in the automotive consulting firm Casesa Shapiro Group, told The Times.

The U.A.W.’s deal with G.M. follows a similar health care agreement it reached with Chrysler, which is also surviving on government loans.

Despite the agreement, Chrysler was forced to file for bankruptcy protection on April 30 after it failed to persuade a group of banks and hedge funds to unanimously agree to take cash payments to retire $6.9 billion in debt.

Now G.M. will make one last push to persuade its bondholders to take equity for their debt.

G.M.’s president, Fritz Henderson, has said repeatedly that bankruptcy is a “probable” outcome because of the difficulty in persuading 90 percent of the bondholders to agree to its restructuring terms.
In the event of a bankruptcy filing, the bondholders may be offered less attractive terms in exchange for their debt.

“The financial community and the union trust have been in competition for this stock,” Mr. Cole of the Center for Automotive Research told The Times. “But with the union deal settled, the pressure is only going to increase on the bondholders.”

Your Retirement Paycheck: Model Portfolios from Kiplingers Magazine

Investments That Pay You Every Month
These three portfolios should produce reliable yields of 5% to almost 10%.

By Jeffrey R. Kosnett

May 4, 2009

In the summer of 2008, I devised three portfolios composed entirely of investments that pay dividends or interest every month. These portfolios are ideal for people who need spending money, as opposed to those who invest in bonds, real estate investment trusts or other kinds of income-oriented vehicles for diversification. The yields on these portfolios ranged from 6% for a mix of moderate-risk bond funds and high-dividend stock funds to more than 10% for a riskier collection of energy royalty trusts, leveraged bank-loan funds and foreign-currency bond funds.



For the most part, the dividends have held up -- the notable exceptions being the oil-and-gas pass-through investments and the bank stocks. But the principal has fallen far more than I imagined even remotely possible. By the time the stock market bottomed in March, share prices for a package of energy income trusts, bank-loan funds and REITs were, on average, half of what they were in mid 2008. If you had started the aggressive, high-income portfolio in June or July of 2008, you were probably down 30% or so on a total-return basis.

Not surprisingly, the lowest-risk portfolio did considerably better, although it, too, was in the red. That package had one-fourth invested in energy and other high-wire stuff, one-fourth in a high-dividend, exchange-traded stock fund, and the rest in Vanguard Total Bond Market Index. The portfolio generated about 8% in income and lost about 20% of its market value -- lousy but, all things considered, tolerable.

Assembling a ladder of Treasury bonds over the past year would have produced a small capital gain, but it would have left you far short of needed income. And that's still true today. You can't build a high-income portfolio -- whether it pays monthly or less frequently -- without taking some risk with your principal.

The good news is that all of these high-risk categories are past the worst. Junk bonds and bank-loan funds have been recovering handsomely in 2009. Ditto for REITs. Payouts -- and share prices -- of oil-and-gas trusts remain depressed, but energy prices and cash disbursements will rise as the world economy improves.

Still, the fact that such formerly trouble-free investments as Enerplus Resources Fund (symbol ERF), a trust that owns a diversified package of energy-producing properties in North America, and Eaton Vance Senior Floating-Rate Trust (EFR), a closed-end bank-loan fund, could lose more than 50% in less than a year is troubling. Many reputable financial advisers and I believed that investments that paid a steady stream of income would be fairly stable. That perception is another casualty of the financial crisis.

So it's time for a new, post-collapse edition of the Cash In Hand Monthly Income Plan. You may have less principal now, but the principle remains the same. You choose from among three approaches: Shoot for maximum yield of 9% to 10%; go conservative and pick up about 5%; or take a middle-of-the-road course. The growing number of bond ETFs (see Welcome Additions: More Bond ETFs), which make monthly distributions, provides some fresh choices. Only a few open-end bond funds, REITs and energy pass-throughs pay 12 times a year (although virtually all Vanguard bond funds pay monthly).

High-risk, high-yield plan
Estimated yield: 9.5%

35%, energy trusts. Energy is still the leading category to hunt for high current income. The typical royalty trust or master limited partnership is priced to yield about 10%. Choose at least three out of a group that includes names such as Cross Timbers Royalty Trust (CRT), Enerplus, Penn West Energy Trust (PWE) and Provident Energy Trust (PVX). All are fairly diversified. Avoid trusts that sell only natural gas. Gas should be a good long-term investment, but there's a surplus of it now and its price will stay depressed longer than oil's price will.

20%, bank-loan funds. The best no-load, open-end fund in this category is Fidelity Floating Rate High Income Fund (FFRHX). Among leveraged, closed-end funds, two possible choices are BlackRock Floating Rate Income Strategies Fund (FRA) and BlackRock Floating Rate Income Strategies II (FRB). In early May, both sported high yields, and their share prices traded at discounts to the value of their underlying assets (that's a must if you invest in a leveraged closed-end). Two parts Fido to one part BlackRock sounds like a good recipe.

15%, corporate junk bonds. Vanguard's low-cost, no-load offering, Vanguard High-Yield Corporate (VWEHX), is the first choice here. Loomis Sayles Bond Fund (LSBRX) is really more of a go-anywhere fund, but it usually holds a substantial amount of its assets in junk bonds and emerging-markets bonds, as well as investment-grade corporates. The fund, a member of the Kiplinger 25, yields about 9.7% and complements the Vanguard fund well.

15%, real estate. The anchor of every check-a-month plan should be Realty Income (O). This is a high-quality, one-of-a-kind REIT that calls itself the Monthly Dividend Company. It owns more than 2,000 properties leased to well-known retailers and restaurant chains. Realty Income has paid 463 consecutive monthly dividends. Not every streak is solid these days, but this one is as close as you can get to a sure thing. Plus, the share price fell far less than that of most REITs during the market's downturn. Realty Income yielded 8% in early May.

10%, preferred stocks. The PowerShares Preferred Portfolio (PGX) is an unleveraged ETF that passes through dividends from an array of preferred bank and utility stocks. It has stabilized after losing half its value from May 2008 to February 2009.

5%, emerging-markets bonds. Two ETFs, iShares JPMorgan U.S. Dollar Emerging Markets Bond (EMB) and PowerShares Emerging Markets Sovereign Debt (PCY), invest in bonds from such places as Russia, Brazil, Turkey, Indonesia and Mexico. After running into trouble in the fall of 2008, the funds, both of which pay monthly, have rebounded handsomely.

The centrist plan
Estimated yield: 8%.

Choose among the same funds, trusts and ETFs as above, but tweak the allocation to make room for a chunk of investment-grade corporate bonds. You could split the high-grade bond exposure between Loomis Sayles Bond and an ETF such as iShares iBoxx Investment Grade Corporate Bond Fund (LQD). The mix:

20%, energy trusts.

20%, investment-grade corporate bonds.

15%, bank-loan funds.

15%, Realty Income.

15%, corporate junk bonds.

10%, emerging-markets bonds.

5%, Vanguard GNMA (VFIIX). The soundest mortgage-related investment around, this Vanguard fund invests in securities backed by the full faith and credit of the U.S. government.

The conservative plan
Estimated yield: 5.5%.

The conservative plan emphasizes the entire range of bonds, including Treasuries (which can't go bust but yield next to nothing and will almost surely lose value if inflation accelerates and if interest rates rise). Then we add some other safe, high-yield categories for balance.

60%, diversified, high-quality bonds. Pick either Vanguard Total Bond Market Index (VBMFX) or its ETF sibling, Vanguard Total Bond Market ETF (BND). You'll get paid about the same each month; the main disadvantage of the ETF is that you incur commissions every time you buy or sell.

10%, energy trusts.

10%, Realty Income.

10%, bank-loan funds.

10%, Vanguard GNMA.


--------------------------------------------------------------------------------
This page printed from: http://www.kiplinger.com/columns/balance/archive/2009/balance0504.html
All contents © 2009 The Kiplinger Washington Editors

Stock-Free Portfolio (from Kiplinger's in the Washington Post)

A Stock-Free Portfolio

Jeffrey R. Kosnett, Senior Editor,
Kiplinger.com
Wednesday, March 11, 2009; 12:00 AM



GOLD (5%)

The yellow metal doesn't pay any income, and it's plenty volatile. But it's a good defense against inflation -- which will surely rear its head when business picks up steam -- and the likelihood of a weaker dollar down the road. With iShares Comex Gold Trust (symbol IAU), you can track the price of gold without having to buy the stuff and store it. It recently traded at $90 per share.
CASH (25%)

With yields generally at less than 1%, cash is trash nowadays. But you won't lose money on your cash investments, and their yields will pick up when the economy recovers and the Federal Reserve begins to lift short-term interest rates. (For ideas on how to invest your no-risk money, see Where to Stash Your Cash Now.)

PREFERRED SHARES OF REAL ESTATE INVESTMENT TRUSTS (15%)

REIT preferreds, like REIT common stocks, have been clobbered this year. As a result, they are delivering extraordinarily high yields. For instance, preferred shares of both Alexandria Real Estate Equities and Corporate Office Properties trust recently yielded 11%, and a Duke Realty preferred yielded 14% (for more suggestions, see A Real Estate Play That Pays).

TAX-FREE-INCOME (15%)

Although interest from municipal bonds is generally exempt from federal income tax, many high-quality munis are yielding far more than Treasuries of like maturity. Some AAA-rated tax-free bonds to consider: Puerto Rico 5.5% general-obligation bond due in 2019. Yields 4.7% to maturity. New Jersey 5.25% transportation bond due in 2022. Yields 4.0% to maturity. University of Texas 5.25% revenue bond due in 2022. Yields 4.0% to maturity.

ENERGY (15%)

Thanks to the recession, oil and natural-gas prices have plunged. But those prices have fallen too far and will almost certainly rise when global economies recover. Two exchange-traded funds -- U.S. Oil Trust (USO) and U.S. Natural Gas Fund (UNG) -- follow these commodities and will appreciate when oil and gas turn up.

BLUE-SHIP IOUS (15%)

These days, high-quality corporate bonds sport unusually generous yields (see Best Buys in Bonds. We found a few that pay well, can't be called before maturity and aren't issued by financial firms: Wal-Mart 5.875% bond due in 2027. Yields 5.6% to maturity. Rated AA by Standard & Poor's. Eli Lilly 7.125% bond due in 2025. Yields 5.4% to maturity. Rated AA. Northern States Power 7.125% bond due in 2025. Yields 6.2% to maturity. Rated A.

Outlook for 2009 from RGE monitor - predicting a LONG Recession

RGE Monitor - 2009 U.S. Economic Outlook

Christian Menegatti, Arpitha Bykere, Elisa Parisi-Capone and Mikka Pineda | Jan 7, 2009

It is clear that 2008 was not a very good year and it is official that the current U.S. recession started already in December 2007. So how far are we into this recession that has already lasted longer than the previous two (1990 and 2001 recessions lasted 8 months each)? We believe the U.S. economy is only half way through a recession that will be the longest and most severe in the post war period. U.S. GDP will continue to contract throughout 2009 for a cumulative output loss of 5% and a recession that will last close to two years.

One last look at 2008 will reveal a very weak fourth quarter with GDP growth contracting -6%, in the wake of a sharp fall in personal consumption and private domestic investments. We see the real GDP growth contraction playing out through the year as follows: Q1 2009 -5%; Q2 2009 -4%; Q3 2009. -2.5%; Q4 2009 -1%, adding up to a yearly real GDP growth of -3.4% for the U.S. in 2009.

Personal Consumption

The resilient U.S. consumer started to give up in the third quarter of 2008, when for the first time in almost two decades, personal consumption contracted. With personal consumption making up over two-thirds of aggregate demand, the outlook for the U.S. consumer is at the center of the dynamics that will play out in the real economy in 2009.

In our view, personal consumption will continue to contract throughout 2009 quite sharply as a result of negative wealth effects from housing and equity market losses, the disappearance of home equity withdrawal from the second half of 2008, mounting job losses, tighter credit conditions and high debt servicing ratios (the debt to income ratio went from 70% in the 90s, to 100% in 2000 to 140% now). This retrenchment of the U.S. consumer will result in a painful rebalancing in the economy that will eventually restore the saving rate of a decade ago.

The wealth losses for households related to the fall in home prices are roughly $4 trillion so far, and are clearly bound to increase further as home prices continue to fall –eventually reaching the $6-8 trillion range (compatible with a 30-40% fall in home prices peak to trough). With a negative wealth effect of 6 cents on the dollar, the reduction in personal consumption could amount to a whopping $500bn. And negative wealth effect from fall in equity prices – on the wake of a bleak 2009 for corporate profits – will also contribute to the contraction in personal consumption by an estimated $100bn (compatible with a 25% contraction in the stock markets).

This adjustment is consistent with a rebalancing of the economy that will over time bring the saving rate to a positive level of roughly 5-6% where it was a decade ago, for this to happen consumption has to contract by an amount close to $800bn.

Housing Sector


The 4th year of housing recession is well on course.

Total housing starts have plunged from the 2.3 million seasonally adjusted annual rate (SAAR) peak of January 2006 all the way to the 625 thousand SAAR of November 2008 (the last data point available), an all time low for the time series that started in January 1959. Single-family starts built for sale are down 75% from their Q4 2005 peak (seasonally adjusted data are not available, we performed our own seasonal adjustment).

On the demand side, new single-family home sales are down 65% from their July 2005 peak. Both demand and supply of homes are therefore still falling very sharply which does not bode well for inventories. Inventories are the mortal enemy of prices for any goods-producing sector, including housing.

Starts need to fall substantially below sales so that the excess supply in the housing market is reabsorbed. Inventories persist at record highs and the gap between one-family starts (for sale) and one-family sales (-92K annual rate in Q3 2008 according to our estimates) is at levels that cannot promote a fast work–off of inventories. To put these numbers in perspective, compare this with a measure of vacant homes for-sale-only. Vacant homes for-sale-only were at 2.2 million in Q3 2008, an all time high. In the decade between 1985 and 1995 it oscillated around 1 million units on average and 1.3 million units between 2001 and 2005. This implies that we have to deal with an excess supply that ranges between 0.9 and 1.2 million units, of which roughly 85% are single-family structures.

The sharp and unprecedented fall of starts might not have reached a bottom yet. In this economy-wide recession, weakness on the demand side is bound to persist and we believe that supply will have to fall further, given also the great wave of foreclosures that is adding to the excess of supply in the market. We see starts falling another 20% from current levels.

We believe that home prices will not bottom out until the middle of 2010. Our target is a 38% peak to trough (so far prices have fallen 25% from the peak) but given the worsening conditions on the real side of the economy, we see a meaningful chance for over-correction that would bring prices down 44% from the peak reached in the first half of 2006 (Case-Shiller is the reference index for these predictions.)

Labor Markets

With continued credit crunch and significant cut down in consumer and business spending, the monthly job losses will continue in the 400-500k and 300-400k range during the first two quarters of 2009 respectively, bringing the unemployment rate to 8% by mid-2009. The severe contraction in private demand until early 2010 will keep lay-offs high and the unemployment rate elevated over 8%.

Economy wide job cuts are expected, with big corporations and small enterprises, residential and commercial construction, financial services and manufacturing continuing to shed jobs at a strong pace. Moreover with structural shifts in the economy since the last recession, job losses this time will be more severe in the service sector, including retail, business and professional services and leisure and hospitality. Unless the fiscal stimulus addresses the deficit problem for state and local government, job losses at the government level will also gain pace. In turn, income and job losses will further push up default and delinquency rates on mortgages, consumer loans and credit cards. Moreover, the loss of high paying corporate and financial sector jobs will be a big negative for tax revenues over the next two years.

Lay-offs are bound to continue thereafter as cost-cutting gains pace with the beginning of the (sluggish) recovery period in early 2010. Even as consumer demand might show some signs of recovery, firms, like in the past, will begin by hiring only part-time and temporary workers initially. The unemployment rate might peak at close to 9% in Q1 2010, almost two years after the recession began. However, the hiring freeze across industries that began in late 2007 will continue at least until 2010 causing discouraged workers to leave the work force and containing the extent of the spike in the unemployment rate. Further, the decline in labor utilization will add to the deflationary pressure in the economy. An aging labor force, lower capital spending and potential growth over the next few years might also result in lower productivity growth and an increase in the natural rate of unemployment (NAIRU).

Capital Expenditure

Firms have been drawing down inventories beginning in Q4 2008. As the slump in domestic and foreign demand and difficulty in accessing short-term credit persist over the next four quarters, business investment is bound to contract in double-digits throughout 2009. Industrial production, spending on equipment and durable goods will also remain in red through 2009. Moreover with a sluggish recovery in private demand even during 2010, firms will start building inventories and contemplate capex plans only at a slower pace.

Trade

Exports contraction that began in late 2008 will gain pace in 2009 as more and more emerging economies slip into slowdown following the G-7 countries. On the other hand, easing oil prices and secular downward trend in consumer spending and business investment will help imports to shrink. In fact, this might cause the trade deficit to contract in 1H 2009 since the contraction in imports might well exceed the decline in exports, thus containing any negative contribution of trade to GDP growth.

Dollar Outlook

The fate of the U.S. dollar in 2009 rests on the global growth outlook. After profit-taking on long USD positions ends and trading volumes pick up as investors return from their holidays, the dollar may temporarily recover its relative safe haven status in H1 2009. Since markets have yet to fully appreciate the impact of the commodity slump and financial crisis on the rest of the world, risk appetite may collapse again on signs of a deeper- or longer-than-expected recession outside the U.S.. Further de-leveraging of USD-denominated liabilities could provide an additional boost to the dollar as a funding currency. The bond yield outlook could be a further source of strength: while the Fed is already at ZIRP, other central banks will cut rates further to stimulate growth, putting downward pressure on currencies like the Euro. Alternating with these upside risks to the dollar may be downside risks from 1) a supply crunch in commodities that lifts commodity prices and producers' economies, 2) inability of the market to absorb increased Treasury supply at low yields.

Downside risks to the dollar seem more likely to outweigh upside risks in the latter half of 2009 and in 2010. Yet at the same time, similar downside risks exist for other currencies – growing fiscal deficits will weaken a range of currencies. With emerging markets continuing to have trouble attracting capital and Asian economies, hammered by export contractions, will be reluctant to allow their currencies to appreciate against or with the dollar – China allowed some depreciation of the RMB at the recent euro-dollar peak.

Once crucial support from deleveraging wanes, however, the dollar may be left with only foreign central bank reserve accumulation, which has already waned on the reversal of capital flows, to finance the large U.S. current account deficit. Continued repatriation of assets and higher enforced domestic savings rates will at least reduce pressure on the dollar in the short-term.

Inflation/Deflation



Annual U.S. inflation, as measured by official producer and consumer price indices, is likely to slow in 2009 and even fall into technical deflation despite increases in the monetary base and fiscal measures to boost spending power. Slumping commodity prices may drag down the average annual headline CPI inflation rate to around -2% - a technical deflation which may morph into genuine deflation if falling prices generate expectations that they will continue to fall. Meanwhile, the growing slack in product and labor markets will keep core consumer inflation subdued at an average year-over-year rate of 1-2%. Steep discounts to get rid of unsold retail inventory, rising job losses and lower wage growth will reinforce the trend of stagnant or falling prices. Loose labor markets and weak demand for commodities and goods/services will keep producer prices at bay. Risks to the outlook include 1) a commodity supply crunch or geopolitical shock that leads to a sustained rise in commodity prices and 2) an earlier than expected global economic recovery.

Credit Losses Still Ahead



Back in February 2008, Nouriel Roubini warned that that the credit losses of this financial crisis would amount to at least $1 trillion and most likely closer to $2 trillion. As of mid-November 2008, the threshold of $1 trillion in global financial writedowns was finally reached. Given that national house prices expected to drop another 20%, we expect credit losses of $1.6 trillion.

An in-depth analysis of current and expected loan losses per asset class and separately of mark-to-market writedowns per securities class based on current prices indeed confirms RGE’s initial loss range estimates (outstanding loan and securities amounts as in IMF GFSR, Table 1.1) For our calculations we assume a further 20% fall in house prices, and an unemployment rate of 9%. With respect to credit losses on unsecuritized loans, recent research by the Fed Board using comparable assumptions (but assuming high oil prices) concludes that over half of 2006-2007 subprime mortgage originations are going to default (i.e. $150bn out of $300bn). The loss trajectories for Alt-A loans are similar resulting in a 25% default rate ($150bn out of $600bn). Even prime mortgage delinquencies display a very high correlation with subprime loan delinquencies, implying an approximate 7% default rate when the potential for ‘jingle mail’ is taken into account ($266bn out of $3,800bn).

The cycle has also turned in the commercial real estate (CRE) arena with the traditional lag of around 2 years. Current serious delinquency plus default rates of 5.9% of CRE loans (net recovery, via Fed data) are projected to increase to up to 17% by Fitch assuming a 25% fall in prices ($408bn out of $2.4 trillion.) In the consumer loan area, we estimate credit card charge-off rate could increase to 13% in the worst case scenario. Adding a typical 5% delinquency rate during recessions, the total loan losses on unsecuritized consumer loans are projected to increase to $252bn out of $1.4 trillion (see The U.S. Credit Card Industry in 2009, by RGE’s Mathias Kruettli.)

The IMF warned that commercial and industrial loans (C&I) charge-off and delinquency rates are likely to climb to historical peaks and potentially beyond in this cycle. Compared to past C&I loan loss rates, we project charge-off and serious delinquencies to reach 10% or $370bn out of $3.7 trillion of unsecuritized C&I loans. With regard to leveraged loans, the latest research by Boston Consulting/IESE Business School based on the 100 largest PE firms engaged in LBOs calculates an expected book loss from default of about 30%. This translates into $51bn out of $170bn unsecuritized leverage loans.

Based on these calculations, RGE expects total loan losses to reach about $1.6 trillion out of $12.4 trillion of unsecuritized loans alone, implying an aggregate default rate of over 13%. The IMF assumes that the U.S. banking system carries about 60-70% of unsecuritized loan losses (and about 30% of mark-to-market losses on securitizations). Even assuming that future loan losses are fully discounted at current market prices, deploying the remaining TARP funds towards recapitalizing the banking system would still be warranted.

The Disconnect Between Bond and Equity Markets



U.S. government bonds were on a tear in 2008, while equities plummeted in a nasty bear market. Bond yields at the long end hit all-time record lows, while the short end even dipped into negative territory. Only TIPS suffered as deflation risks rose. Stocks, on the other hand, had their worst year since the Great Depressions: DJIA lost 34%, S&P 500 -38.5%. At its 2008 low on November 20, the S&P 500 was down 49% for the year and 52% from its October 2007 peak. Stocks rallied in December though, resulting in an apparent disagreement between the stock and bond markets over the outlook for the U.S. economy. Bond markets seemed to be discounting a recession in 2009 while stock markets have been gaining since late November. This disconnect may vanish in 2009 though if the stock market rally was really just a bear market rally due to portfolio re-balancing and thin year-end trade volumes.

However, there have been intimations that the bond market is in a bubble about to burst in 2009. Indeed, with ultra low bond yields, investors may be tempted to switch into higher-yielding equities - which are now considered by many to be undervalued. Valuation, however, is not the be-all and end-all of asset performance. The credit freeze needs to end before equities can see the end of the bear market. However, considering the likely economic stagnation ahead, bonds should be a better bet than equities for some time. We see meaningful downside risks to stock prices as bad macro news – worse than expected – continues to dominate in 2009. Using the S&P 500 as benchmark, earnings per share will stay in the $50-60 range – and earnings will fall further. If, and it is not unusual during recessions, P/E ratio falls in the 12-14 range, we could see another 25% slide in stock prices.

Fiscal and Monetary Policy

Fiscal Policy

A lot of hope is being placed on the expected fiscal stimulus package of around $750 bn spread over 2009-10 including 40% of the stimulus in tax cuts for households and firms. Around half of the stimulus is expected to kick-in starting Q2 2009 and through 2010. But this will fall short of the pull-back in private demand of close to $1 trillion during this period.

Infrastructure spending, in spite of being highly effective, might not be timely, stimulating the economy only in late-2009 and 2010 when it has well passed the severe recession phase only to exacerbate the ballooning fiscal deficit. Nonetheless, around $100bn of infrastructure investment might be able to kick-in during 2009. Moreover, job creation in infrastructure might be overestimated given limitations in moving laid-off workers from other sectors to the infrastructure projects. As such, any job creation via government spending and tax incentives for firms will significantly fall short of the ongoing lay-offs.

Given the drawback of the ‘spending’ component of the stimulus, the government may be enticed to implement more tax cuts. While tax incentives for households like payroll and child tax credit might be well-targeted at the group with high propensity to spend, tax cuts in general will be less effective in stimulating demand given a secular rise in the saving rate expected over the next few years. Likewise, tax breaks for firms hiring new workers or investing in new equipment will be rather ineffective since businesses see little viability in doing so during a slump in domestic and export demand. At the most, tax stimulus in spite of being timely and well-targeted will cause only a temporary rebound in the economy for a month or a quarter merely shifting the spending decision period just like tax rebates did in 2Q 2008.

Expansion of unemployment benefits, food stamps and other incentives will have a high bang-for-buck effect in 2009 and will only assuage the impact of the recession. The stimulus will also include up to $100 bn for state and local governments to meet their severe budget shortfalls including grants, Medicaid and unemployment insurance funds, preventing cutbacks in public services, investment and jobs in several recession-hit states. But again, fiscal aid for states often suffers from time lags.

Fiscal stimulus, TARP spending, GSEs-related expenditure along with further slowdown in corporate and individual income tax revenues will push the fiscal deficit to around $1.3 trillion in FY2009.

Monetary Policy

The Fed has enacted a wide and unprecedented range of measures to mitigate the credit crisis and stimulate the economy. It has already cut its target range for the Fed funds rate down to 0-0.25% (essentially ZIRP) but, more importantly, it has created currency swap lines and an alphabet soup of programs to provide liquidity to the financial system and clean out toxic financial assets. The Fed experimented with different forms of financing itself in order to enable a sharp expansion of its balance sheet to accommodate these liquidity facilities. In addition to rate cuts and quantitative easing, the Fed has directly aided failing financial institutions. Now, the Fed is considering issuing its own debt and/or purchasing long-dated Treasuries and Agency debt. Will the monetary easing work? So far, the increase in money supply has not been accompanied by an increase in the velocity of money. In other words, credit growth remains stagnant as banks are reluctant to lend back out the money provided by the Fed and, at the same time, borrower demand has fallen.

What the Ratings Mean (Moody's, Standard & Poors)

BOND RATINGS – What the Grades Mean

When considering a potential investment, investors should compare the credit qualities of available corporate bond issues before they invest. The two most recognized rating agencies that assign credit ratings to corporate bond issuers are Moody's Investors Service (“Moody’s”) and Standard & Poor's Corporation (“S&P”).

In determining the creditworthiness of an issuer, Moody's and S&P focus on a company's overall financial condition as well as that of the industry in which the issuer operates. A rating represents the opinions of the rating agency at a particular point in time. Ratings on individual issues are continuously revised to reflect any industry or company developments, and these ratings changes can have a distinct effect on an issue's market price. Moody's and S&P classify corporate bond issues as either "investment grade" or "below investment grade”, briefly summarized below:

Investment grade bonds are generally more appropriate for conservative clients. These bonds typically provide the highest degree of principal and interest payment protection, and they are generally the least likely to default.

Below investment grade bonds may be suitable for more aggressive clients willing to accept greater degrees of credit risk in exchange for significantly higher yields.




Investment Grade Moody's S&P


Highest Grade: Aaa AAA
Moody's These bonds are judged to be of the best quality. They carry the smallest degree of risk. Interest payments are protected by an exceptionally stable margin and principal is secure.
S&P The issuer’s capacity to meet its financial obligation on the bond is extremely strong.


High Grade: Aa1, Aa2, Aa3 AA+, AA, AA-
Moody's These bonds are judged to be of high quality by all standards. Margins of protection may not be as large as in Aaa securities.
S&P The issuer’s capacity to meet its financial obligation on the bond is very strong.


Upper Medium Grade: A1, A2, A3 A+, A, A-
Moody's These bonds possess many favorable investment attributes. Factors giving security to principal and interest are considered adequate.
S&P Although these bonds are somewhat more susceptible to the adverse effects of changing economic conditions, the issuer’s capacity to meet its financial obligations is strong.


Medium Grade: Baa1, Baa2, Baa3 BBB+, BBB, BBB-
Moody's The bonds lack outstanding investment characteristics and have speculative characteristics as well.
S&P Adverse economic conditions are more likely to lead to a weakened capacity of the issuer to meet its financial commitment.


Below Investment Grade Moody's S&P


Speculative Grades: Ba1, Ba2, Ba3 BB+, BB, BB-
Moody's The future of these bonds cannot be considered as well-assured. B1, B2, B3 B+, B, B-
S&P These bonds face exposure to adverse business or economic conditions which could lead to an issuer’s inadequate capacity to meet its financial commitment.


Highly Speculative Grades: Caa1, Caa2, Caa3 CCC+, CCC, CCC-
Moody's These bonds are of poor standing. Such issues may be in default, or there may be elements of danger with respect to principal or interest. Ca CC
S&P These bonds are vulnerable to nonpayment, and are dependent upon favorable economic conditions for the issuer to meet its financial commitment. C C


Default
S&P These bonds are in payment default. D

The Yields are Staggering - Tax Free Muni Bonds (Barrons)

Monday, October 20, 2008






The Yields Are Staggering
By ANDREW BARY

Many munis are battered -- but hardly broken. Patience will pay.

THE CREDIT MARKET'S WOES are benefitting one group: buyers of municipal bonds, who have seen prices plunge and yields soar. Munis, some of which offer long-term tax-free yields topping 6%, have almost never looked so attractive, relative to U.S. Treasuries.

"The market is way undervalued," says Laura Milner, a portfolio manager at SCM Advisors in San Francisco. "It's more the result of liquidity than credit problems. You don't have to stretch in terms of credit quality to get high yields." She favors state general-obligation bonds and revenue bonds for essential services, like water and sewers.

THE MARKET HAS BEEN HURT by selling pressure from hedge funds, issuers of structured notes and mutual funds, which have been experiencing redemptions. Buyers have been scarce, with retail investors now the main source of demand. The problem is that individuals can absorb only so much supply. There also is concern that the weakening economy will lead to gaping budget deficits at state and local governments, hurting the credit quality of municipal debt. Investors can take comfort, however, in the fact that munis historically have had much better credit performance than corporate bonds. Even during the Great Depression, no state defaulted on its general-obligation bonds, and overall muni default rates remained very low.

Just last week, 30-year bonds backed by the triple-A-rated Texas Permanent School Fund (PSF), one of the premier muni guarantors, were sold at a yield of 6.25%. Double-A-rated New York City issued $500 million of general-obligation bonds at a top yield of 6.40%. Top-grade 10-year debt recently has been yielding 5% or more.


Lars Leetaru for Barron's
"The yields are staggering," says Jim Evans, who heads the muni investment group at M.D. Sass in New York. Evans points to the top yield on the Texas PSF bonds and to recent secondary-market offerings in which 20-year pre-refunded California GOs traded at a yield of 5.85%. Pre-refunded bonds probably are the safest bonds in the muni market because they're secured by U.S. Treasuries. Long-term debt from other top issuers, like Harvard University, yields nearly 6%

A 6% muni yield is equivalent to a 10% taxable yield for residents of high income-tax states like California, New Jersey and New York. This assumes that residents buy in-state bonds. Tax-equivalent yields for out-of-state bonds are around 9%. The allure of munis could grow if presidential front-runner Barack Obama wins the election because he has vowed to raise taxes on Americans making more than $250,000 a year. Some analysts expect Obama to seek to lift the maximum income-tax rate to 40% from the current 35%, which now applies to married couples earning over $357,700 a year.



The 5.9% yield on 30-year, AAA-rated munis now is roughly 135% of the 4.3% yield on the 30-year Treasury. That's by far the highest ratio in the past 20 years, exceeding the prior peak of 115% set early this year. Long-term municipals historically have yielded slightly less than Treasuries because of the tax benefits.

Despite weak demand for long-term issues, California just sold $5 billion of short-term revenue-anticipation notes maturing in 2009, including $3.8 billion of eight-month notes at a 4.25% yield. That yield is very attractive, relative to the 1% rate on Treasury bills. The interest is tax-free to California residents, who face a punishing state income-tax rate of 9.3% for couples earnings over $93,000 annually and 10.3% for income above $1 million.

Muni issuance has slowed dramatically this month as state and local governments have heeded the advice of investment bankers to wait for a more receptive market. If demand picks up -- and high yields could create demand -- supply might be easily absorbed, and market conditions could improve quickly, as they did after a sell-off in February and March.

Investors have plenty of ways to play the muni market, including individual bonds, open-end mutual funds, closed-end funds and relatively new exchange-traded funds like the iShares S&P National Muni Bond (MUB). Well-run open-end funds include the $19 billlion Vanguard Intermediate-Term Tax-Exempt (VWITX) and the Bernstein Diversified Municipal (SNDPX), which have held up well this year, as well as Legg Mason Partners Managed Municipals (SMMOX), co-run by veteran Joe Deane, one of the best managers in the business.

CLOSED-END MUNI FUNDS BECKON because they came under extreme selling pressure early this month, with many finishing Friday, Oct. 10, at record discounts of 30% or more to their net asset values, way above the typical level of no more than 10% or 15%. Exchange-traded closed-ends rallied sharply last Monday, and their discounts now generally are below 20%.

The accompanying table lists a few closed-end funds now trading at double-digit discounts and yielding more than 7%. The high closed-end yields reflect the discounts and leverage. Many funds buy $3 of bonds using $2 of investor funds and $1 of borrowings. The leverage results in higher volatility than is common at open-end funds; year-to-date total returns of many closed-ends were a negative 20% or worse at mid-week, according to Morningstar, versus declines of around 10% for many long-term open-end funds. The losses to closed-end investors have been even greater than 20% because market prices often slip more than NAVs, on which the reported performance data are based. There's a risk that some closed-ends will reduce leverage, diminishing their yields.

PROBABLY THE HARDEST-HIT big municipal fund this year is the $5.9 billion Oppenheimer Rochester National Municipals (ORNAX), which was off 37% through Thursday, by far the worst showing among the 50 largest open-end muni funds.

The aggressive fund aims to generate high yields through ownership of low-rated or unrated munis. It buys gamier securities like land-development bonds, tobacco bonds backed by state revenues from the 1998 mass settlement with major cigarette companies, airport-revenue bonds and "inverse floaters," whose yields move in the opposite direction of short-term rates. With muni short rates elevated, prices of inverse floaters have come under pressure.

Prices of bonds in the Rochester portfolio have fallen sharply as investors favor high-grade munis with ratings of AA and higher. "I've been doing this since the late 1970s, and this is by far the worst I've seen it. It's an ugly market out there," says Ron Fielding, senior portfolio manager of the fund. Because of recent investor redemptions, Oppenheimer's Rochester has been forced to sell bonds in an illiquid market.

Fielding says the good news is that the credit quality of both the Oppenheimer Rochester National Municipals fund and the larger $9 billion New York-oriented Rochester Fund Municipals (RMUNX) is strong with minimal defaults. The main near-term risk is that the funds will need to sell more bonds to meet additional redemptions. The national fund's current yield now stands at 10%.

Reflecting the investor preference for high-grade munis, the yield gap between triple-A and triple-B munis has widened to a near-record two percentage points.

Even among highly rated bonds, investors are showing a preference for general-obligation bonds and revenue bonds from well-regarded issuers like the Los Angeles Department of Water and Power and the Port Authority of New York and New Jersey.

The Bottom Line:

Municipal bonds are trading at unusually low prices and rare yields. They've almost never looked as attractive when compared with U.S. Treasury securities.A BLOCK OF BONDS issued by Goldman Sachs for construction of its new headquarters in lower Manhattan traded recently at a yield of about 7.75%. Those New York Liberty 5¼s of 2035 are backed by Goldman and have double-A credit ratings.

With the municipal-bond market roiled by liquidity problems, investors now can get 5% on intermediate-term debt and 6% on long-term issues. That seems awfully attractive with inflation likely waning and the presidential front-runner vowing to boost taxes on anyone making $250,000 or more a year.


--------------------------------------------------------------------------------

E-mail comments: mail@barrons.com

URL for this article:
http://online.barrons.com/article/SB122429125462346821.html










Related Articles from Barrons.com
Sharing the Wealth Oct. 18, 2008

Current Yield Oct. 18, 2008

Munis Fail to Get a Bailout Boost Oct. 15, 2008

After a Record Tumble, Is Junk a Bargain? Oct. 12, 2008




Related News from WSJ Digital Network
Vanguard's Values Oct. 15, 2008 marketwatch.com

Port in the Storm: Insurers' Catastrophe Bonds Oct. 14, 2008 wsj.com

Munis thrive in troubled market Oct. 07, 2008 marketwatch.com










Copyright 2008 Dow Jones & Company, Inc. All Rights Reserved
This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones Reprints at 1-800-843-0008 or visit www.djreprints.com.