How to Invest in a Rising Rate Environment (Morningstar)

Libor Rising to the Occasion

By Emory Zink | 02-02-17 | 06:00 AM | Email Article

This  article appears in the February 2017 issue of Morningstar FundInvestor.  

The three-month London Interbank Offer Rate (Libor) surpassed 1 percentage point in early January 2017, a first since May 2009 for the widely referenced interest benchmark. The rate is derived by polling roughly 20 or so global banks on a daily basis for quotes of what they would charge other banks to borrow money for three months, dropping the outliers, and calculating an average. The result is used as a base rate for trillions of dollars in financial transactions and provides insight into liquidity and lending risk in the fixed-income markets. When Libor is higher, borrowing is more expensive, and when it is lower, funding is cheaper to access.

The 1% level may look modest, particularly given that Libor touched 5.7% in 2007, but relative to the rate’s post-financial crisis fate—it sat beneath 0.6% from June 2009 until nearly the end of 2015—its more recent ascent was notable. In 2016, it inched upwards, gaining momentum in the second half of the year as money market regulatory reforms hit full stride. The latter spurred many large investors to move assets out of prime money market funds with significant credit exposure into money markets composed of mostly government securities. Redemptions among prime money market funds trimmed demand for commercial paper and certificates of deposit, which in turn raised borrowing costs, and thus Libor’s levels. In fact, many ultrashort bond funds benefited from this structural adjustment, stepping in to snap up higher-yielding instruments at attractive prices leading up to and after the formal Oct. 14, 2016, date that money market reforms kicked in. The flexible  PIMCO Short-Term (PTSHX) and more buttoned-up  Fidelity Conservative Income Bond(FCONX) are two of our favored active ultrashort bond funds that have benefited from these market dislocations.

Bank loan investors have also benefited from the rise in three-month Libor. Minimum payouts for loans—typically referred to as floors—became ubiquitous after the rate plummeted during the financial crisis, and most floors stipulated that loans would continue to pay at least 1% plus a designated spread, even if Libor were to remain below that level. When three-month Libor rises and exceeds those 1% floors, though, as it did in early 2017, and loans began hitting their 90-day resets (typically) their coupons began floating higher to levels of Libor plus that additional yield premium built into each loan. Essentially, as Libor moved higher, floating-rate loans and notes based on that rate began to look more attractive.

The real question now is whether Libor will continue its climb. The U.S. Federal Reserve has hinted that it will likely gradually hike its own federal-funds rate in the coming months and years—Libor typically tracks that level closely during normal market conditions—which implies a trend of higher borrowing costs, if not necessarily a steep one. With prime money markets shrinking, ultrashort bond funds should likely continue to benefit by answering a healthy supply of commercial paper with selective demand, but there is no guarantee that supply won’t stagnate if borrowers seek less-costly forms of financing.

Perhaps even more important, though, is the impact that a rising Libor will have across an even broader expanse of financial markets given that most derivative transaction prices are linked to that rate, as well. It may seem like an obscure financial industry tool, but Libor is ultimately one of the most important rates affecting the entire global financial system.

Emory Zink is an analyst covering fixed-income strategies on Morningstar’s manager research team.

Preferred Stocks Frequently Asked Questions (from Incapital.com)

Preferred Security FAQs

• How do I purchase preferred securities?
• What are cumulative and non-cumulative dividends?
• Are preferred securities callable?
• Is the income from preferred securities taxable?
• Where do preferred securities stand in the priority of claims?
• Where can I get a prospectus or prospectus supplement?

---

HOW DO I PURCHASE PREFERRED SECURITIES?

After syndication, most public preferred securities are traded on an exchange.  The most widely used is the New York Stock Exchange.  They also trade over-the-counter through broker-dealers who make markets in various preferreds.  Privately-placed preferreds trade through a broker-dealer or directly between investors.

WHAT ARE CUMULATIVE AND NON-CUMULATIVE DIVIDENDS?

Preferred stock dividends are either cumulative or non-cumulative.  Cumulative dividends are due to shareholders irrespective of an issuer’s profitability.  If an issuer has trouble meeting its financial obligations and does not pay a cumulative dividend, dividends accrue and the company is obligated to pay all past and currently due preferred dividends before paying common dividends.  If a company does not pay a non-cumulative dividend, it is not obligated to do so in the future.  Non-cumulative dividends do not accrue beyond one year and the issuer is still permitted to pay common dividends the year following an omission if preferred payments recommence.  In either case, a company is not automatically considered in default if it misses a payment as it would be by missing a bond payment. 

ARE PREFERRED SECURITIES CALLABLE?

Preferred securities may be callable, in which case the issuer has the right to purchase the securities from the investor at a predetermined date and price.

IS THE INCOME FROM PREFERRED SECURITIES TAXABLE?

Income from preferreds with the exception of Trust Preferreds is taxable as ordinary income unless it is Qualified Dividend Income (QDI) and/or Dividend Received Deduction (DRD) eligible.  QDI and DRD eligibility depends on factors relating to the structure, issuer and investor.

Income from Trust Preferreds and Baby Bonds is considered interest and taxable as ordinary income.

The tax treatment of preferred securities varies.  However, investors should not rely on these taxation provisions, as they may change.  Incapital does not provide tax or financial advice.  Please read the tax section of the prospectus and prospectus supplement and consult a qualified tax professional before investing.

WHERE DO PREFERRED SECURITIES STAND IN THE PRIORITY OF CLAIMS?

The priority of claims refers to the order in which investors receive their share of a firm’s net worth upon liquidation.  Preferred securities rank junior to bonds and senior to common stock in the priority of claims against a company’s assets in the event of bankruptcy or reorganization.  The diagram below illustrates the capital structure priority.  A preferred’s place may vary depending on its specific characteristics outlined in the prospectus and prospectus supplement.

This Priority of Claims diagram is for illustrative purposes only.  Each security’s offering documents will govern the issue’s priority.

WHERE CAN I GET A PROSPECTUS OR PROSPECTUS SUPPLEMENT?

The prospectus and prospectus supplement for public offerings are available on the SEC’s website.   

High Yielding Hybrid Securities (Alliance Bernstein)

Bank Hybrids Bloom Globally—with Subtle Variations

 Matthew Minnetian, Shrut Vakil  August 10, 2015  Asia-Pacific, Fixed Income/Bonds

The market for financial hybrid securities is growing as banks worldwide implement stringent new capital rules. But not all hybrids are alike, so investors can’t afford to take a one-size-fits-all approach.

These securities do have important common features. Because they were created to comply with the Basel III global banking regulations that aim to improve banks’ ability to withstand financial stress, all of them can be written down or converted to equity if the issuing bank runs into trouble. This process ensures that shareholders and creditors will bear the cost of any future bank rescue, not taxpayers.

Banks around the world have already issued more than $200 billion of Additional Tier 1 (AT1) securities, which would be the first bonds to absorb losses in a crisis, and we expect issuance to nearly double in the years ahead (Display 1).

Even so, these securities have important structural differences that can affect performance, and pinpointing the most attractive opportunities requires disciplined analysis and global expertise.

It’s the Economy—and the Credit Cycle

The first thing managers need to navigate this growing market is a deep understanding of regional economic conditions and credit cycles around the world. For example, banks in the US and Europe are several years into the process of building up capital and reducing risk, leaving their banking sectors stronger and healthier than they were before the financial crisis.

At the same time, the economic backdrop has brightened considerably in the US and the UK, while the euro area appears to be in the early stages of a recovery. As we pointed out in earlier posts, this combination of stricter regulations and improved fundamentals makes US preferred securities and European AT1 debt attractive.

With stronger balance sheets, US and European banks are less likely to run into the kind of trouble they did in 2008. That strength helps offset the risk of losses on these assets and means investors can pocket the high yields they offer in exchange for their lower perch in the capital structure. So far this year, yields on these assets have been above those available from BB-rated US high-yield debt (Display 2).

Things look different in other parts of the world. Managers might want to take a more cautious approach in countries more sensitive to commodity prices or in those that have recently undergone credit booms and rapid home price increases. A slowdown in economic growth in these instances could lead to a spike in bad loans and trigger increased volatility in banks’ outstanding hybrid securities.

Of course, it’s also important for managers to do their homework when it comes to individual banks, no matter what their country of origin, which means having a strong handle on a bank’s fundamental health and credit metrics. Put another way, managers should be comfortable investing in a bank on a stand-alone basis.

Regulatory Regimes: Read the Fine Print

Variations in local regulatory regimes matter, too. For instance, in the US, any form of exceptional government support for banks—think the 2008 bailouts—would trigger the mandatory write-down or conversion-to-equity provisions on US preferred securities.

That’s not so in Japan, where the rules were written to give the government the flexibility to support banks in certain circumstances, without automatically triggering write-downs and exposing investors to losses. Astute managers need to understand these subtle differences.

Understanding Structural Nuances

At a more micro level, managers will need a deep understanding of the structural features of individual securities. Again, while the structure is broadly similar across securities and regions, there are subtle differences. These differences can sometimes cause the market to mis-price securities, providing astute investors with opportunities to boost relative value in their portfolios.

An AT1 security from a European bank priced in US dollars might, for instance, trade differently than one priced in euros. Investors also need to be aware of the varying supply-and-demand factors in different markets, which can affect how these securities are priced.

Raising the Regulatory Bar

As with any investment, there are risks associated with these Basel III–compliant securities. For some investors, the possibility of being wiped out in a crisis may be too big a risk to bear. But as we’ve noted, the level of risk in this sector varies, depending on the individual security, the issuing bank, and the regional economic and regulatory environment.

What’s more, global regulators have shown no sign of easing up on banks. Regulations are becoming more stringent and are being applied more widely. As a result, many banks will continue to reduce leverage and hold more capital as a cushion against losses—things that should be music to any bondholder’s ear.

We think those factors make hybrid securities a promising way to potentially boost returns in a low-yield environment. But global know-how and thorough analysis are critical for making the most of this growing opportunity.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams

Combat Inflation with Floating Rate Securities (Forbes)

Fixed-Income Watch
Inflation Protection For Free
Richard Lehmann, 09.12.11, 6:00 PM ET

I have been pounding the table warning about rising interest rates for some time now. Well, it hasn't happened yet, and the latest Fed pronouncement makes it clear that short- and long-term rates will likely stay low for the next two years. My fear of rising rates caused me to recommend adjustable-rate securities. I was wrong on inflation, but my floating-rate picks have done quite well.

Since 2009 the adjustable-rate securities have enjoyed a spectacular resurgence, because most of them were issued by banks and other financial institutions that suffered huge declines during the financial crisis. These "too big to fail" institutions needed capital, and they issued all kinds of paper to bolster their books.

While fixed-rate issues experienced a similar rise, they are hurt by their call provisions. Specifically, most of the issues with a 5% or higher coupon rate are likely to be refinanced. This means they're trading on a yield-to-call basis with measly returns measured in basis points rather than percentages (100 basis points equals one percentage point). Most are trading above the par value at which they will be redeemed. Those who bought fixed-rate capital note preferreds with high coupons, issued by the troubled banks in 2008, thought they would be safe from call until 2013. Not so.

Congress and the Dodd-Frank Act foiled this seemingly smart strategy. That act says these preferreds can no longer be considered part of a bank's tier-one capital. This triggers a "statutory change" loophole that now allows banks to call these fixed-rate preferreds early. Think of it as Chris Dodd's going away present to his banker buddies.

Adjustable-rate securities normally trade at lower yields than comparable fixed-rate securities. They pay interest monthly or quarterly based on a Treasury bond index, LIBOR or changes in the CPI. The floating rate means these notes are designed to trade at par. But this hasn't been happening. That is because these securities come with an interest rate floor, typically at about 4%. When these bonds were issued that was considered meager. Today a 4% yield is a king's ransom.

Despite the healthy yield floor, most of these adjustables are selling below par today because they are viewed as inflation hedges in a period when inflation fears are absent. Thus you can still buy these adjustable-rate securities below par value. That is like getting a dollar for 90 cents. Hence, inflation protection is free, and the call risk is a positive. Once inflation fears are rekindled and rates spike, you'll be all set with these floating-rate securities.

Here are some adjustables you should consider buying:

AEGON NV SERIES 1 (AEB, 17) PERPETUAL PREFERRED RATED BAA2/BBB/BBB. This Dutch multi-line insurance giant was hard-hit during the financial crisis and still suffers under the weight of European banking concerns. This preferred is adjustable quarterly based on three-month LIBOR plus 87.5 basis points. It has a 4% floor and no ceiling, so at its current price it yields 5.71%. Even better, it's eligible for the 15% qualified dividend income tax rate for those in the highest tax bracket.

Closer to home I like GOLDMAN SACHS SERIES A PERPETUAL PREFERRED (GS A, 19) RATED BAA2/BBB–/A–. It has a floor rate of 3.75% and no ceiling and is tied to three-month LIBOR plus 75 basis points. It yields 4.93%, and it also benefits from the preferable tax rate on dividend income.


If you are willing to accept more risk buy the SLM CORP. 0% OF 3/15/17 (OSM, 21) RATED BA1/BBB–, yielding 6.15%. SLM is better known as Sallie Mae, the student loan organization, which went private in 2004. This adjustable is different in that it pays monthly, based on the percentage change in the year-over-year Consumer Price Index, plus 200 basis points. It has no floor or ceiling rate and currently pays 5.164%. I like it because there is no delay in recognizing an uptick in inflation, but unfortunately it isn't eligible for lower tax treatment.

I thought rates would climb because the Fed would use inflation as its primary tool in curing our economic woes. Bernanke flooded our economy with dollars, but inflation failed to materialize. Our economy was much weaker than I thought. Dark clouds still hang over global markets. While inflation is not an immediate concern, it can and does crop up when it's least expected. Given the current international turmoil and clearly nervous markets, investments offering inflation protection at no cost are a gift I find hard to resist.

Why You Should Wait: Fixed Annuity Rates are Still Too Low (Morningstar)

The Error-Proof Portfolio:

For Annuities, Timing Is Key

By Christine Benz | 04-12-10

Many investors' hackles go up when you say the word "annuity." They immediately think of variable annuities, many of which are pricey and often sold, not bought. (When the TV program Dateline is using hidden cameras to catch salespeople in the act of peddling inappropriate products to unwitting seniors, it's fair to say that an industry has an image problem.)


But plain-vanilla single-premium immediate annuities deserve more respect. The concept is as simple as it can be: You give the insurance company a slice of your retirement portfolio, and the insurer, in turn, sends you back a stream of income for the rest of your life. You can layer on additional bells and whistles--such as survivor benefits in case you die early in the life of the contract--but they will dramatically decrease the payout you'll receive.


The Value Proposition
The idea of using annuities as a slice of retiree portfolios has been gaining traction in the financial-planning community and among mainstream investors during the last few years. Against the backdrop of a rocky stock market and a shrinking number of defined-benefit plans, annuities' promise of a certain payout holds a lot of appeal. And with bond yields still exceptionally low right now, annuities are also attractive in that they generally deliver a higher payout than what a retiree would receive via a traditional high-quality fixed-income investment.


Annuities also help address the more basic problem that--regardless of the market environment--we're all planning for an unknowable time horizon. None of us knows how long we'll live. And increasing life spans increase the risk that a portfolio of stocks and bonds (that is, one without an annuity) might not last throughout a retiree's lifetime, thereby burnishing annuities' appeal.


Problematic Timing
For all of these reasons, it's become conventional wisdom that SPIAs should be part of retirees' toolkits. Unfortunately, fixed annuities are catching on at what could, in hindsight, be the worst possible time. That's because the payout you receive from an annuity is based on two key factors: 1) the expected life spans of other annuityholders and the likelihood that some of them will die before actuarial tables would suggest; and 2) the interest rate that the insurance company can expect to earn on your money.


The first factor--in essence, the fact that some unlucky people in the annuity pool will die before their time--is why annuities can provide a higher payout than fixed-rate investments. In a pool of hundreds of people, the statisticians know that at least some of the folks who should live into their 80s and 90s will expire in their 60s and 70s instead. Those early decedents will have paid more into the annuity than they've gotten out. Other annuitants, meanwhile, will live well beyond what the actuarial tables would suggest, enabling them to receive more than they've put into their retirement.


The wrinkle is that people are living longer, and insurance companies are having to spread the money in the annuity pool over more and more very long lives, so increasing longevity will have the side effect of shrinking the payouts for everyone. (As a side note, an interesting body of research indicates that annuity pools include significant adverse selection--that is, the people who are most likely to buy an annuity are also likely to live much longer than actuarial tables would suggest. That may be because those most attracted to annuities may have longevity in their families, or perhaps there's a correlation with wealth and better health care.)


That trend will provide a long-term headwind for annuities, but it shouldn't have a significant impact on the timing of when you buy an annuity. The other component of annuity payouts--the interest rate the insurance company can expect to earn on your money--is more problematic. If you buy an annuity today, the currently ultra-low interest-rate environment will depress the payout you receive. (It's not a perfect analogy, but it's somewhat akin to buying a long-term bond with a very low coupon. Rates may go up in the future, but you'll be stuck with your low payout.) The average fixed annuity rate plunged from 5.55% to 3.94% between December 2008 and December 2009, according to National Underwriter.

What to Do?
For those who like the concept of an annuity but are concerned about the effect of low interest rates on payouts, one possibility is to ladder your investments, essentially dollar-cost averaging in to mitigate the risk of buying an annuity when interest rates are at a secular low. If, for example, you were planning to put $100,000 into an annuity overall, you could invest $20,000 into five annuities during the next five years. Such a program, while not particularly simple or streamlined, would also have a beneficial side effect in that it would give you the opportunity to diversify your investments across different insurance companies, thereby offsetting the risk that an insurance company would have difficulty meeting its obligations.


Alternatively, a prospective annuity purchaser could simply wait until fixed-income interest rates head back up toward historical norms. While fixed-income yields have recently begun to climb, they're still extremely low relative to historic norms.

Best bargains in Muni Bonds Now (Barrons)

How to Play the Panic in Muni Bonds
By RANDALL W. FORSYTH

For several months, panicked investors have been pulling cash from muni-bond funds. For investors of means, that presents an opportunity to lock in high tax-free yields for a decade or more.

Since mid-November, panicked sellers have yanked about $26 billion from muni-bond funds, disrupting a usually orderly market. For investors of means, that presents an opportunity to lock in high tax-free yields for a decade or more.

Doing so, however, takes more care than buying a muni exchange-traded fund or closed-end fund.

The undeniable crisis in public finances has moved from the political background to the top of the news in recent months. The demonstrations by Wisconsin public employees protesting the governor's drastic measures to close the state's budget deficit are only the most dramatic examples of the fiscal pressures being felt all across the nation.

But the budget problems in states and localities are not nearly as dire as those of the sovereign debtors in Europe, though you might not know that from the coverage in the popular media. Most notably, analyst Meredith Whitney predicted an imminent day of reckoning for state and local governments in a December interview with CBS News' 60 Minutes. "You could see 50 sizable defaults," she asserted. "Fifty to 100 sizable defaults. More. This will amount to hundreds of billions of dollars' worth of defaults."


Last week, a consulting firm formed by "Dr. Doom," Nouriel Roubini, chimed in with a similar forecast of $100 billion of defaults, which had no discernible impact on the muni market.

Whitney's unsupported prediction of default -- vastly in excess of that seen in the Great Depression of the 1930s -- helped push muni prices down about 10% for long-term bonds. Her assertions have been met with a deluge of criticism from muni-bond professionals, as well as in the pages of Barron's and on Barrons.com. Yet many pricing anomalies persist. Investors willing to buy individual bonds and hold them to maturity can get yields as high as 5% on highly rated paper. That's equivalent to a taxable yield of nearly 7.7%.

The bonds themselves provide the assurance of repayment of principal at maturity, which provides a measure of confidence even as their prices may fluctuate. Mutual funds, whether equity or fixed-income, are worth only what they fetch that day; there is no assurance that they will recoup their losses and return the original investment.

Among the securities to look for are bonds backed by clearly defined sources of money, including thruways, water and sewer systems and state lottery revenues.

Profiting from Panic
Other factors also conspired to make for a perfect storm for municipal bonds. The Treasury market -- which determines the broad trend in other bond markets, including munis -- also has been under pressure until recently as yields rose on increasing fears over inflation and investors' preference for risk assets. In addition, the end of the Build America Bond program on Dec. 31, which provided a federal subsidy to states and localities issuing taxable bonds, added to pressures. The BABs program meant less issuance of traditional tax-exempt securities, which had bolstered their prices and kept a lid on their yields. The sunset of BABs at the end of 2010 lifted that lid. The BABs program also was important in broadening the municipal market to institutional and global investors not interested in income free from U.S. income tax, the main lure for American individual investors.

The carnage is particularly visible in the iShares S&P National AMT-Free Municipal Bond exchange-traded fund, a quick and easy proxy for the muni market. It shed more than 10% in value from its peak in August to its trough in January and still trades 6.4% below its high.

In the process, extraordinary values have emerged as yields on tax-exempt municipals rose to equal or even exceed those of taxable Treasury or corporate bonds. Taking in munis' tax advantage, high-quality tax-exempt bonds exceeded the after-tax yields on junk bonds. Around the muni market's nadir in January, tax-free yields on investment-grade California general-obligation bonds were higher than the yields on lower-quality, fully taxable bonds of Mexico or even Colombia.

While that portion of the investing public who take their investment cues from TV were stampeding out of munis, savvy and sophisticated investors were going the other way. And even as a backlash against the doomsayers for their unsupported predictions of multibillion-dollar defaults increased, they dismissed their critics as peddlers of munis merely defending their turf.

Other disinterested and distinguished observers have pointed out how undervalued munis are.

MKM Partners' chief economist and strategist, Michael Darda, who made a perfectly timed call to buy deeply depressed but high-quality corporate bonds at the depths of the 2008 financial crisis, called valuations on munis "increasingly compelling" with higher prospective after-tax returns than medium-grade corporate bonds or equities.

David Rosenberg, chief strategist at Gluskin Sheff, one of Canada's top wealth-management firms, adds that only single-B junk corporates provide the same after-tax yield as investment-grade munis. "I can't think of a security that is going to provide a U.S.-based investor a 7% annual return for the next decade with such little risk attached -- not equities, not corporates, not commodities. I still think this is the biggest opportunity out there in the investing world today and the most glaring price anomaly."

As the pace of fund liquidations has slowed to about $1 billion a week from $4 billion at the worst of the exodus in January, the muni market has begun to recover, with the iShares muni ETF up about 5% from its mid-January trough. In addition, issuers of municipal bonds deferred new offerings amid an inhospitable market.

Despite the undeniable value that munis represent, the dilemma remains for investors. As the news coverage of the budget battle raging in Madison, Wis., dramatically shows, state and municipal finances never have been under such stress.

But, as Clifford D. Corso, chief executive and chief investment officer of Cutwater Asset Management, points out, debt service makes up a small part of the expenses for states and localities -- in contrast to the sovereign debtors of Europe, for which interest and principal payments place a huge burden on their budgets.

The impact of the budget cuts being played out in state capitals and city halls across America will fall on public schools and the poor, as Howard Cure, director of municipal research at Evercore Wealth Management, a New York firm that manages separate accounts for high-net-worth individuals and families, ruefully observes.


Moreover, muni pros agree that states and localities have powerful incentives not to default in order to maintain their access to the capital markets. That is a direct contrast to the mortgage market, to whose parlous condition the municipal market has been compared, not entirely aptly. Borrowers whose mortgage balances are greater than their homes' values have engaged in what's euphemistically called "strategic defaults."

Yet the pressures on municipal finances are "episodic, not systemic," Cure adds. In other words, not every city is in the same dire straits as Harrisburg, Pennsylvania's capital, which averted default through by an advance from the state.

The greater risk in municipal bonds, most market professionals agree, is the same as for all fixed-income securities -- higher yields resulting from a more ebullient economy, rising inflation or both, which would be expected to lead to further losses. That has them taking some tacks that may appear counterintuitive.

Ken Woods, who heads Asset Preservation Advisors in Atlanta, which specializes in fixed-income management for high-net-worth individuals, is targeting a slightly longer duration for his clients' portfolios, which are concentrated in the intermediate-maturity range.

But for lengthening duration -- in a structure called a barbell -- he is concentrating on the very shortest maturities, under two years, and relatively longer ones out to eight-to-12 years. In the process, he's avoiding the middle of the range, which would be hurt the most by an increase in short-term interest rates by the Federal Reserve.

Corso of Cutwater Asset Management is taking the same barbell approach, concentrating on the short end and the long end of the market and avoiding intermediates. That is a strategy to deal with the extreme steepness of the muni yield curve -- the much greater yields paid on the longest maturities relative to shorter ones, which are anchored by the Fed's targeting of the overnight federal-funds rate near zero.


THIS ISN'T EUROPE
Headlines blare news of state and local budget woes, but many munis promise handsome returns. Especially appealing: bonds issued by agencies facing only modest retiree benefit costs.


Sample Portfolio
Maturity S&P Moody's Book Yield*

Texas A&M University 5/15/2012 AA+ Aaa 0.57%
San Antonio TX Elec & Gas 2/1/2014 AA Aa1 1.38
State of Pennsylvania GO 2/1/2014 AA Aa1 1.22
State of South Carolina GO 3/1/2016 AA+ Aaa 1.81
State of Utah GO 7/1/2016 AAA Aaa 1.85
Sutter Health - California 8/15/2016 AA- Aa3 3.37
Salt River Arizona Power Authority 1/1/2018 AA Aa1 2.53
State of Virginia GO 6/1/2019 AAA Aaa 2.54
Ascension Health - Michigan 11/15/2019 AA Aa1 3.87
State of Delaware GO 3/1/2020 AAA Aaa 2.75
State of Maryland GO 3/1/2021 AAA Aaa 2.90
Water/Sewer District of Southern California 3/1/2022 AAA Aaa 3.50
State of Texas GO 4/1/2023 AA+ Aaa 3.49
Massachusetts Institute of Technology 7/1/2023 AAA Aaa 3.42
State of North Carolina GO 5/1/2024 AAA Aaa 3.53
NYC Transitional Finance Authority 2/1/2025 AAA Aa1 4.17
Massachusetts Bay Transit Authority 7/1/2026 AAA Aa1 4.17
NYC Water/Sewer Authority 6/15/2028 AA+ Aa2 4.42
Charlotte NC Water/Sewer 7/1/2030 AAA Aaa 4.23.
Harvard University, Mass. 12/15/2031 AAA Aaa 4.27
Tallahassee, Fla. Health Facilities 12/1/2030 NA Baa1 6.43%
Halifax Hospital Medical Center, Fla. 6/1/20206 A- BBB+ 5.70
Northampton City, Pa., Hospital Authority 8/15/2024 BBB+ A3 5.58
Michigan Hosp. Fin. Auth. (Ford Health) 11/15/2039 A A1 6.28
Iowa Higher Ed. Ln. Auth. (Grinnell Col.) 12/1/2020 AAA Aaa 3.12
State of Washington GO 1/12/2020 AA+ Aa1 3.00
Illinois Fin Auth. (Swedish Covenant Hosp.) 8/15/2029 BBB+ A- 5.81
Denver City & Co Sch Dist. Colo 12/1/2021 AA- Aa2 3.30
*As of 03/02 Sources: Cutwater Asset Management & Asset Preservation Advisors
.
The muni yield curve's steepness parallels that of the Treasury market out to 10 years, but it becomes even more extreme for lengthier maturities. Two-year triple-A munis yield about the same as the two-year T-note -- as of March 3, around 0.72%. At 10 years, the muni yields 3.20% vs. 3.52% for the Treasury. But in 30 years, the muni yields 4.72% vs. 4.60% for the Treasury. For a taxpayer in what for now is the top federal tax bracket of 35%, the top-grade muni yields the equivalent of 7.26%, the same as better-grade corporate junk.

If, or when, the steepness of the muni yield curve corrects, with short- and intermediate-term yields likely moving higher, those on the short end of the barbell will be trading as near-cash equivalents and will be able to be redeployed at higher returns.

Historically, the long end typically doesn't move much in those circumstances, so the investor picks up significant yield with little price movement. In the less likely event the curve flattens from the long end, the lengthier maturities would rally.

Woods also is emphasizing medium-grade (triple-B and single-A) bonds to a greater extent since going down the quality scale provides greater-than-usual pickups in yield. But he does that for only some 15%-20% of portfolios, with 80%-85% in double-A or triple-A bonds instead of his usual 85%-90% in top grades.

Another emphasis is on longer-term, high-coupon callable bonds. For instance, instead of buying a bond maturing in eight or 10 years, Woods might buy a bond due in 18 years but callable in eight years with a high enough coupon to ensure it is called. These so-called kicker bonds provide a higher yield and lower volatility than comparable non-callable bonds. That's in part because they trade at a significant premium to par, and individuals not steeped in the arcane math of bonds are loath to pay above par.

Cure of Evercore emphasizes bonds outside the battlegrounds of budget deficits and future pension and retiree health-care benefits. While the news focus is on states and cities, there are thousands of bonds that are issued by various agencies. These securities have structures with clearly defined sources of money, either dedicated tax payments or revenues from the projects they finance.

In New York, Cure explains, personal-income-tax payments are dedicated to payment of bonds of the Housing Finance Agency, the Dormitory Authority and Thruway Authority. In Florida, there are bonds secured by state lottery revenues, which have to cover debt service three times.

Revenue bonds to finance essential services such as water and sewer systems also have the virtue of being relatively immune to vagaries in the economy, which affect income and sales-tax revenues. In addition, localities which depend on real-estate levies have been depressed by the drop in house prices.

Meanwhile, those authorities also have relatively few employees and lower future retirement liabilities than, say, school districts.

And just think of the satisfaction you'd get paying the toll on George Washington Bridge if you owned bonds of the Port Authority of New York and New Jersey, which operates the Hudson River crossing.

.E-mail: editors@barrons.com

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Floating Rate Notes to Cope with Rising Interest Rates (Wall St Journal)

Floating-Rate Notes Resurface As Economy Grows Again

By Katy Burne of DOW JONES NEWSWIRES

NEW YORK (Dow Jones)--Corporate borrowers are switching up the composition of their debt sales, throwing more floating-rate notes into the mix to entice investors who believe interest rates may be about to rise sooner and faster than expected.

Nearly $26 billion, or 23%, of the investment-grade bonds marketed in the U.S. so far this year have had floating rates, according to data provider Dealogic, making it the busiest January for so-called floaters since 2007. That compares with $57.4 billion, or 7% of the supply, for all of 2010.

Bankers expect to see more floaters this year for two reasons: Issuers are suddenly comfortable selling them; and investors are eager to buy them to position their portfolios for a potential rise in rates.

"People have had the view for the last year, or year and a half, that short-term rates aren't going higher any time soon, and that is not an environment where you think you can make money on floating-rate debt," said Jim Merli, head of debt origination and syndicate at Nomura Holding Americas Inc.

"Now that is starting to change," Merli added, "because there is stronger economic data, and other central banks outside the U.S. are making noises about raising short-term rates."

Data over the last few months have been supportive of a more bullish outlook on the economy, with more job creation, a rising stock market, and strong corporate earnings over the past two weeks.

"While there are certainly headwinds like unemployment and weak wage gains, the data is far more balanced and the growth camp seems to have the scales tipping in its favor," said David Ader, head of government bond strategy at broker-dealer CRT Capital Group.

To be sure, floating-rate deals account for only a fraction of the market share they had in the middle of the last decade, and the volume outstanding has fallen by 40% since end of 2007 to $428.9 billion now. But issuers are warming up to them again.

Financial institutions tend to be the biggest issuers of floating-rate debt, to bring their funding in line with assets such as floating-rate loans. Financial firms, including insurers as well as banks, have accounted for 63% of the U.S. high-grade issuance in dollar volume so far this year, the highest percentage for any January since at least 1995, when Dealogic started keeping records.

About 57% of that total was from banks, although units of non-financials like brewer Anheuser-Busch InBev SA/NV and energy giant Total SA have recently issued floaters, too.

AB In-Bev's strategy of pairing fixed- with floating-rate debt was "a function of the expected long-term recovery of the economy versus the short-term opportunity to benefit from historically low rates," said Scott Gray, director of global funding and financial markets at the company in New York.

Johnson Controls Inc. was in the market Tuesday with $350 million of three-year floating-rate notes as part of a $1.6 billion deal.

Heavy issuance by foreign banks has also contributed to the rise in these securities. They borrow in the U.S. because investor appetite is stronger here than in their domestic markets. January saw the largest volume of these so-called Yankee deals--dollar-denominated bonds sold by foreign firms in the U.S.--than any other month on record.

"Since the euro markets were less friendly to new issuance, floater deals that would normally have come as euro bonds were instead dollar issues," said Guy LeBas, chief fixed income strategist at Janney Capital Markets in Philadelphia.

Most of the floating-rate debt sold this year has been clustered around two- and three-year maturities, as was the case in 2009. Last year's issuance was more evenly spread between three-, five- and 10-year floaters, helping to stem the pace at which maturing debt exceeded new supply.

There is about $32 billion of floating-rate, Federal Deposit Insurance Corporation-insured bonds under the government's Temporary Liquidity Guarantee Program maturing this year, said LeBas, all of which needs to be refinanced--including $5 billion in the first quarter.

"Given that all the government-guaranteed debt from 2009 is maturing in 2011, banks will be able to issue short-term floaters beyond that maturity cliff," said Justin D'Ercole, head of Americas investment-grade syndicate at Barclays Capital. "As opposed to the last two years, when it would have had the effect of adding to their massive wall of maturities, it now fits into their debt-distribution profile."

LeBas said while there is marginally greater demand for floaters based on concerns about rising rates, investors are better off buying short-dated, fixed-rate debt. If rates rise and the income on the bond resets progressively higher, an investor would win out over time only if rates rise enough to offset the lower income in the early going.

"Rates would have to rise quite rapidly for it to make sense to accept such a low initial coupon," he said.

Last Thursday, ABN AMRO Bank N.V. sold $2 billion of fixed- and floating-rate bonds, with the $1 billion of floaters pricing at 1.77 percentage points over Libor, equivalent to a coupon of 2.07%, and the $1 billion of fixed-rate notes pricing with a coupon of 3%.

"Investors are using these floaters to shorten duration and express their view on the pace of future Fed tightening," said Michael Hyman, head of investment-grade credit at ING Investment Management, who participated in the ABN AMRO deal.

-By Katy Burne, Dow Jones Newswires; 212-416-3084; katy.burne@dowjones.com

The Sleep at Night Portfolio: Make Your Own Pension (WSJ)

New ways to create a gold-plated pensionBY ELEANOR LAISE,
The Wall Street Journal
The Wall Street Journal — 10/30/10
The financial crisis has given some investors a case of pension envy. In an era of volatile markets, the idea of steady, guaranteed payments for life holds obvious appeal.
The problem, of course, is that investors are less likely than ever to get that kind of deal from their employer. Companies tend to be freezing their pensions or closing them entirely, rather than beefing them up. About a third of today's Fortune 100 companies have frozen or closed a pension plan since 1998, according to consulting firm Towers Watson.

But that doesn't mean investors can't set up their own. New tools are emerging to help investors fashion portfolios that mimic the steady payments generated by the pension plans of yore.

The trick: to focus more on constructing a portfolio to cover future expenses—not just maximize returns—and to rethink old retirement-planning rules of thumb, such as a "safe" portfolio withdrawal rate of 4% annually.

Financial firms and advisers are catering to the demand for pension-like portfolios. New bond-based products can be tailored to produce income to pay living expenses for a period of, say, five or 10 years, leaving a significant chunk of the portfolio to invest in higher-growth assets with long-term potential. Some target-date mutual funds, meanwhile, are aiming to match their investments to the expenses investors face in retirement.

The new strategies often mean heftier helpings of bonds and inflation-fighting investments like real estate and commodities. While bigger bond holdings can mean lower returns, the approach also can give investors the confidence to stick with the more volatile stock investments in other parts of their portfolio, advisers say—reducing the chance they will sell shares at a market bottom.

When investors know that a few years' worth of basic expenses are covered by safe, high-quality bonds, "they can sit back and worry a whole heck of a lot less" about stocks' ups and downs, says Joe Chrisman, director at wealth-management firm Lourd Capital Management, which uses a pension-style approach with clients.

The most painful part of the process may be simply saving more. Since the financial crisis, "there's been a much greater recognition that the markets are not going to rescue everyone," says Timothy Noonan, managing director at Russell Investments. Building a secure retirement "is not a function of going and finding higher returns."

The pension approach seems to work: Over the long term, defined-benefit pension plans have outperformed 401(k) plans by roughly 1 percentage point annually, according to Towers Watson.

Small investors can't—and shouldn't—invest exactly like pension plans, though. For a pension plan acting on behalf of many beneficiaries, with people entering and retiring each year, the age of an individual worker makes little difference. But a person investing on his own must tone down portfolio risk—and generally accept lower returns—as he approaches retirement.

Pension plans also can buy into some investments that most small investors can't access, such as hedge funds and private equity, and get better deals on fees.

That isn't to say pension plans have some magic formula. Many suffered big losses in 2008, for example, though overall they held up better than 401(k)s, according to Towers Watson.

Neither type of retirement plan provides the perfect answer, says Zvi Bodie, a finance and economics professor at Boston University School of Management. "We need to combine the best of both."

Annuities may seem the simplest solution for investors seeking a steady income stream. One approach: Buy an immediate annuity that provides for basic expenses, leaving other parts of the portfolio to cover nonessentials. A number of firms now are working to marry funds with annuities within 401(k) plans.

Still, many advisers suggest investors first consider the greater flexibility, and often lower costs, that can come with a do-it-yourself approach.

A homemade pension plan starts by acknowledging that people, like companies, have a balance sheet with both assets and liabilities, advisers say. The liabilities include the money you will spend on food, shelter, travel and other expenses. Yet advisers and money managers traditionally have focused mostly on the assets, trying to maximize investment returns for a given level of risk.

Pensions, by contrast, are more likely to employ liability-driven investing, choosing particular investments to match their future expenses. Investors can do this, too—by buying long-term bonds, for example, to match payments to be made decades from now.New tools can help people size up future expenses. At goalgami.com, a free calculator launched earlier this year by financial-planning technology firm Advisor Software Inc., people can enter information on their income, assets, debt and long-term goals like real-estate purchases. Taking a lifetime view of the "household balance sheet," rather than a single snapshot, the tool analyzes whether future sources of cash will pay the bills and cover other retirement costs.

Most people want to maintain their standard of living in retirement. So if you have just retired and live comfortably on $100,000 a year, you want that income to keep up with inflation as long as you live, says Tom Idzorek, chief investment officer at Morningstar Inc.'s Ibbotson Associates.

A "laddered" portfolio of Treasury inflation-protected securities, or TIPS, can help. Investors who buy TIPS that mature in each year of retirement ensure a steady income stream that rises with inflation and matches spending, Mr. Idzorek says.

Ibbotson in recent years has been designing target-date fund strategies with retirement liabilities in mind. It has built two sample portfolios—one using traditional asset allocation and one with a liability-focused approach—that have roughly the same allocations to stocks and bonds. But the liability-focused portfolio allocates roughly 28% to assets that can act as inflation hedges, including commodities and real estate, versus about 16% in the traditional portfolio.

Since people are likely to spend their retirement money in U.S. dollars, they also can more closely match their assets with their liabilities by investing more in U.S. stocks and bonds as they approach retirement, Mr. Idzorek says. In the sample portfolios, the liability-focused approach devotes only about 8% to non-U.S. holdings, versus about 18% in the traditional portfolio.

The liability-focused portfolio's expected return, 5.9%, is only slightly less than the 6.4% expected in the traditional portfolio, according to Ibbotson.

Of course, given the recent bond rally, it can be pricey to match many years' worth of retirement expenses with TIPS and other bond investments. Asset Dedication LLC, a Mill Valley, Calif., money-management firm, aims to address that by building custom bond portfolios to produce precisely the income to cover client expenses for a given number of years, leaving plenty to invest in higher-growth assets.

The firm's Defined Income product, launched this year, invests in certificates of deposit, TIPS and other high-quality bonds and holds them to maturity. Bulking up on fixed-income might seem counterintuitive right now. But by holding bonds to maturity and then rolling them over, the strategy can capitalize on higher yields later.
If a client wants to spend $50,000 in each of the next five years but also wants to buy a vacation home in year three, the account can help plan for that, says Mr. Chrisman of Lourd Capital, which uses the Asset Dedication program and other liability-driven strategies with clients.

Mickey Patrick, 57 years old, says his do-it-yourself pension allows him to stop worrying about short-term stock-market swings. Mr. Patrick, a technology manager in Houston, earlier this year started investing most of his individual retirement account in TIPS, CDs and other high-quality bond holdings. Though several financial advisers had told him to keep most of the money in stocks, Mr. Patrick determined that the account needed to cover only about one-fourth of his retirement spending, since a pension and Social Security would provide the rest—and therefore he didn't need to take that much risk.

"They said I was crazy," Mr. Patrick says. But while he used to check market moves daily, now "I don't worry at all about it," he says.

People who are focused on matching investment assets with retirement "liabilities" challenge some conventional retirement-planning wisdom. One rule of thumb says investors should have a stock allocation equal to 100 minus their age. (A 40-year-old, for example, would keep 60% in stocks.) But Boston University's Mr. Bodie says risk-averse investors, even younger ones, might want to put most of their money in safer assets.
Bob Kirchner, 63, a retired economist in Fort Washington, Md., has found that a liability-matching strategy reverses the traditional planning process. Instead of first deciding to put, say, 50% in stocks, he says, it's "let's get all this safe stuff lined up first," leaving stock decisions for later. He now has more than half of his portfolio in TIPS.

Liability-driven investing also involves rethinking the "safe" portfolio-withdrawal rate. Many advisers say retirees can withdraw 4% of their initial retirement balance a year, adjusting annually for inflation. But while the 4% spending rule is rigid, the investments tend not to be. Someone might automatically spend a preset amount, disregarding the fact that his portfolio has gained or lost, say, 30% over the past year. With the 4% rule, "there's a chance you'll wind up with nothing, and there's a bigger chance you'll leave quite a bit," says William Sharpe, a professor of finance, emeritus, at Stanford Graduate School of Business.

A bill introduced in Congress last year would require 401(k)s to show participants a projected monthly retirement income based on their current account balance, instead of just a simple lump sum. Russell Investments is developing tools to help financial advisers look at similar metrics for clients' portfolios, says Russell's Mr. Noonan.

If investors can look at their progress in terms of their personal goals rather than market events, Mr. Noonan says, "it's easier for them to remain invested when the market is doing scary gyrating things."
--------------------------------------------------------------------------------


Copyright © 2010 Dow Jones & Company, Inc. All Rights Reserv

Obama and Annuities (New York TImes)

January 30, 2010
Your Money
The Unloved Annuity Gets a Hug From Obama
By RON LIEBER
Annuities: The official retirement vehicle of the Obama administration.

As slogans go, it’s hardly “Keep Hope Alive,” or even “Change We Can Believe In.”

But there were annuities, in a report from the administration’s Middle Class Task Force that came out this week. They are among the tools the administration is promoting as it tries to give Americans a better shot at a more secure retirement.At its simplest, which is how the White House seems to want to keep it, an annuity is something you buy with a large pile of cash in exchange for a monthly check for the rest of your life.

If the biggest risk in retirement is running out of money, an annuity can help guarantee that you won’t. In effect, it allows you to buy the pension that your employer has probably stopped offering, and it can help pick up where Social Security leaves off.

President Obama did not discuss annuities in his State of the Union address on Wednesday night, probably figuring that viewers had enough problems staying awake. But the mere mention of them by the task force was enough to send executives at the insurance companies that sell the products into paroxysms of glee.

“I never thought I’d have the president as a wholesaler for us,” said Christopher O. Blunt, executive vice president of retirement income security at the New York Life Insurance Company. “This is awesome. I’m trying to see if I can get him to do a big broker meeting for us.”

He’s unlikely to turn up for such an event just yet. After all, the announcement from the White House did make it clear that the administration was looking to promote “annuities and other forms of guaranteed lifetime income.” That suggests the administration is open to other solutions, though there are not many others that are as simple as the basic fixed immediate annuity (also known as a single premium immediate annuity) that delivers a regular check for life.

Still, all of this attention from the president is a stunning turn of events for a rather unloved product. Many consumers reflexively run in fear when salesmen turn up pitching high-cost and complex variable annuities, which evolved from their simpler siblings decades ago. Today, the Securities and Exchange Commission maintains an extensive warning document on its Web site for investors considering the variable variety.

Meanwhile, almost all employees on the precipice of retirement who have access to annuities as a payout option steer clear when their companies offer them. While various surveys show that roughly 15 to 25 percent of corporations offer annuities to workers who are retiring, including big employers like I.B.M., a 2009 Hewitt Associates study reported that just 1 percent of workers actually bought one.
“I joke sometimes that we’re the best ice hockey players in Ecuador,” said Mr. Blunt of New York Life, which sells more fixed annuities than any other company, according to Limra, a research firm that tracks the industry.

So what are these soon-to-be retirees so afraid of? And what makes the White House so sure it can change their minds?

Let’s start with the fears. Early on, the knock on annuities was that once you died, the money was gone. So let’s say a 65-year-old man in Illinois turned over $100,000 in exchange for $632 a month for life, a recent quote from immediateannuities.com. If he died at 67, his heirs would get nothing while he would have collected only about $15,000. (On the other hand, it would take him until age 78 to get $100,000 back, but that doesn’t take inflation into account.)

The industry solved this by coming up with variations on the policy, allowing people to include a spouse in the annuity or guarantee that payouts to beneficiaries would last at least 10 or 20 years. This costs extra, of course, meaning your monthly payment is lower.

Others worried about inflation, so now there are annuities whose payments rise a few percentage points each year or are pegged to the Consumer Price Index. These cost extra, too (often a lot extra).

You see the pattern here. Every time someone had an objection — the need for a bunch of payments at once, a lump sum in an emergency or concern about rising interest rates — the industry created a rider to add to policies to make the concern go away (and make the monthly payment smaller).

Besides, people need to have saved enough to purchase a decent monthly annuity payout in the first place. But plenty of retirees haven’t been saving in a 401(k) or individual retirement account long enough to have a good-size lump sum.

There are also stockbrokers and financial planners standing in the way. Once money goes into an annuity, they can’t earn commissions from trading it anymore and may not be able to charge fees for managing it. Financial advisers have a charming term for this phenomenon — annuicide. You insure, and their revenue dies. So, many of them will try to talk you out of it.

One reasonable point they might make is that insurance companies can die, leaving your annuity worthless. State guaranty agencies exist, but they may cover only $100,000 to $500,000. I’ve linked to a list of the agencies in the Web version of this column so you can see what they insure.

Even if you get over all these mental hurdles, however, the hardest one may be the difficulty of seeing a big number suddenly turn small.

“It’s the wealth illusion, the sense that my 401(k) account balance is the largest wad of dollars I’ll ever see in my lifetime, and I feel pretty good about having that,” said J. Mark Iwry, senior adviser to the secretary and deputy assistant secretary for retirement and health policy for the Treasury Department. “Meanwhile, I feel pretty bad about the seemingly small amount of annuity income that large balance would purchase and about the prospect of handing it over to an entity that will keep it all if I’m hit by the proverbial bus after walking out of their office.” So how might the Obama administration solve this? It could get behind a Senate bill that would require retirement plan administrators to give account holders an annual estimate of what sort of annuity check their savings would buy. That way, people would get used to thinking about their lump sum as a monthly stream.

Tax incentives could help, too. A recent House bill called for waiving 50 percent of the taxes on the first $10,000 in annuity payouts each year. “If this is behavior that the administration is trying to inspire, then it’s not that long of a leap to think that maybe they’ll start to promote some version of these bills,” said Craig Hemke, president of BuyaPension.com, which sells basic annuities (and offers some good educational material for people who are trying to learn about the products).

Mr. Iwry, who is one of the intellectual architects of the administration’s examination of annuities, wouldn’t say much about what might happen next. But one paper he co-wrote two years ago suggests a clue.

As the treatise suggests, the administration could nudge employers into automatically depositing, say, half of new retirees’ lump sums into a basic annuity or other lifetime income product, unless they opt out. Then, they could test the thing out for two years and see how that monthly paycheck felt. If they liked it, they could keep the annuity. If not, they could cancel it without penalty and get the rest of their money back.

Annuities won’t be right for everyone (people in poor health should probably steer clear). And they’re not right for everything because it rarely makes sense to put all of your money in a single product or investment.

You could, for instance, use an annuity to cover the basic expenses that your Social Security check doesn’t cover. You might also use the money to buy long-term care insurance, which would keep nursing home bills from becoming a budget-destroyer.

But the president has one thing right: The basic annuity is almost certainly underused. Sure, you may be able to arrange a better income stream on your own, but not without a lot of help from a financial planner or a lot of time managing it yourself. Then there’s the possibility, however small, that you’ll spend too much in spite of yourself or run into a once-in-a-generation market event that will cause you to run out of money sooner than you expected.

All of that makes basic annuities the ultimate test of risk aversion. If you buy some, you and your heirs may have less money than if you’d kept your retirement savings in investments. Then again, if you guarantee enough of your retirement income, you — and those same heirs — won’t have to worry about how you’re going to meet your basic needs.

Bonds that Keep Up with Inflation (Forbes)

Forbes.com
Intelligent Investing Panel
The Case For Corporate Bonds
Alexandra Zendrian 02.10.10, 6:00 AM ET


Corporate bonds and equities have much in common--they have both had significant rallies since last March, and there are still opportunities in both markets for those willing to look for them.

"Default rates are down, and corporate earnings are improving," says Calvert Investments Chief Investment Officer Cathy Roy. She advises investors to buy corporate bonds from companies with strong fundamentals. Roy adds that investors should buy short-term bonds with durations of between two and five years as interest rates are slated to go up soon.

Knowing this Roy says floating-rate bonds are a good defensive play, as when interest rates go up these bonds get a boost. Calvert is underweighting mortgage-backed securities, as there doesn't seem to be a natural buyer in that market, and is also underweighting Treasuries.

Some financial advisors say corporate bonds are the best of a beleaguered bunch. To wit, corporates are in a much better place relative to Treasuries, says Shannon Zimmerman, an analyst with Motley Fool. This is because much of corporate America is deleveraging, while the government is taking on more debt.
.

Still, since higher interest rates and inflation seem increasingly imminent, bonds could be adversely affected.

As a result, Zimmerman says to look to bond alternatives. One way is for investors to take about half of their fixed-income assets and put them into blue-chip dividend stocks like: Johnson & Johnson, PepsiCo, Coca-Cola Company and Kraft Foods. That way investors gain a more steady income stream through dividends but remain exposed to the upside of equities market.

This is also the time to consider Treasury Inflation-Protected Securities (TIPS), Zimmerman says. TIPS prosper in an inflationary environment because they rise with inflation.

In this recovery Advisors Asset Management Chief Executive Officer Scott Colyer anticipates lower-quality corporate bonds will recover better than higher-grade ones. Why? Because during recoveries riskier investments tend to outperform safer ones.

Not all agree. Brent Burns, president of wealth management firm Asset Dedication, says that investors should aim for higher-rated bonds because of their security. Since he anticipates some AAA companies will not maintain that status for long, he recommends AA bonds, as AA is the new AAA.

Burns recommends investors purchase individual bonds as they provide more control over their portfolio than an exchange-traded fund. This is because with an ETF you are stuck with the entire basket of bonds, whether you want them all or not. LPL Financial Chief Investment Officer Burt White also sees some opportunities in investment-grade corporate bonds. "Once corporations embark on a path of deleveraging and cleaning up balance sheets, corporate bonds benefit over long periods of time," he says. He adds that "corporate credit-quality trends tend to be long-lasting." White says that as companies' balance sheets get healthier, "the prospect for narrower yield spreads suggests additional room for improvement."

Though White sees opportunities in investment-grade corporate bonds, high-yield bonds remain his firm's favorite fixed-income investment. "Following the past two recessions in the early 1990s and 2000s, high-yield bonds posted impressive outperformance for the subsequent two years following a bottom in the economy and a period of underperformance," he says. White anticipates these bonds delivering high single-digit or low double-digit returns.

Other financial advisors prefer exchange-traded funds. "Most individual investors probably shouldn't buy individual bonds because of the lack of diversification," says Klingman & Associates Chief Executive Officer Gerry Klingman. He recommends the iShares IBOXX Dollar Investment Grade Bond Fund ETF and mutual funds such as the Dodge and Cox Income Fund (DODIX) and Vanguard Intermediate-Term Investment Grade Fund (VBIIX).

Investors mindful of the potential rise in interest rates can also try the Leader Short-Term Bond Fund (LCCMX). It's top five holdings are the Freeport-McMoran Copper & Gold Floating-Rate Note, Fifth Third Bancorp FRN, Citigroup FRN, Hertz 10.5% and General Electric Capital Corp.

John Lekas, president of Leader Capital, adds that investors should avoid emerging market funds because they can become so volatile so quickly. For an example, one need look no further than Dubai, where news of widespread defaults sparked a near panic.

Preferred Stock Basics (Montreal Gazette)

A mini-primer on preferred shares


By JOHN ARCHER, Freelance December 7, 2009

With interest rates remaining stubbornly low, investors hankering for yield are finding slim pickings in the term-deposit and bond market.

One area of fixed income investing that tempts yield seekers is the preferred-share market, where yields are ranging from four per cent to 6.5 per cent. Preferred shares remain a mystery to the average investor, however, so here is a quick primer.

Preferred shares carry attributes similar to bond and stock investments. Preferred shares, like common shares, represent a form of ownership in a corporation.

The fact that preferred shares are traded on a stock exchange sometimes confuses investors, whereas preferred shares should be purchased primarily as and evaluated against fixed income instruments.

Some characteristics are common to all preferred shares: As an equity investment, preferred shares rank above the interests of common equity holders. As well, the preferred-share investor is entitled to a set rate of dividend that must be paid out of earnings before any dividends are distributed to common shareholders. It should also be noted that dividends receive favourable tax treatment relative to other forms of income.

Finding value in the preferred-share market can be a challenge for the individual investor, which is why using an adviser is recommended. Furthermore, preferred shares can be bought only through an investment dealer, though dividend mutual funds are more widely available.

The following factors should be considered before making a preferred share investment: Calculate the yield on the investment. The easiest way to evaluate the yield on a preferred share is to measure the current yield - the dividend divided by the market price. Current yield, however, does not account for accrued dividends, capital gains or losses realized when the share is purchased at a price different from the redemption value, or the lower taxation rate on the dividend income.

A different measure of yield for preferred shares is the "bond-equivalent yield," which provides an all-in rate of return (based on purchase price, dividend payments, lower tax rates on dividend income, and the maturity value). The bond-equivalent yield is then compared with bonds of similar term to provide a gauge of relative value. The greater the difference (spread) between the preferred share's bond-equivalent yield and the yield on Government of Canada bonds of similar term, the greater the value to the investor.

Other factors to consider in purchasing preferred shares include knowing the issuer's credit rating. Investors should also understand other risks associated with preferred shares, like interest rate risk, as preferred shares are often affected by changes in interest rates. Should interest rates rise, existing preferred share prices may fall. The longer the preferred share's maturity, the more sensitive it will normally be to interest rate changes.

While there might be a learning curve involved in adding preferred shares to your income portfolio, comparing their superior yields to those of other fixed income investments should reward you in today's low interest rate environment.

Copyright (c) The Montreal Gazette