How to Recognize Bond Market Extremes
It’s Time for a New Paradigm
Stocks to Start an Income Portfolio
Traditionally, investors thinking about retirement have invested in a mix of stocks and bonds designed to balance safety and growth. The closer to retirement or more risk-averse they are, the more of their portfolio they hold in bonds for safety and regular income. The system has even been institutionalized in the form of “target-date funds” that automatically put more of your holdings in bonds as you near retirement.
But today, more and more investors are questioning this model. Specifically, the interest rates of the last few years have forced many investors to rethink the bond portion of their portfolio.
Bonds just don’t fulfill the needs of retired investors any more: Interest rates are so low they don’t provide enough income to live off of, and most bonds will actually lose value over the next few years. Ten-year bonds issued recently have yields under 2%. Treasury Inflation-Protected Securities (TIPS) are actually being issued today at negative yields. (At the January 31 Treasury auction, 10-year TIPS were issued with an interest rate of -0.63%.)
Not only are those interest payments too insignificant to fund your retirement, but once interest rates begin to increase (which they will, eventually) those low-yielding bonds will fall in value. Bonds that are being issued at just slightly below face value today will most likely be worth significantly less than face value in a few years.
Buying newly-issued bonds today would be foolish.
But it’s hard to throw an entire investment paradigm out the window. The fact is, though, it’s not the first time bond investors have had to adapt to a new paradigm. Thirty-two years ago, in 1981, 30-year Treasury bonds were being issued with yields of 15%. And previously-issued 30-year bonds were selling for huge discounts: a 30-year bond issued in 1970 that yielded 7.875% could be bought for 56% of face value in 1981.
Yet, investors thought bonds were a terrible investment. A bond trader quoted in the New York Times that year said, “Anyone who buys a bond today to hold for more than five years is out of his mind.”
The reason was high inflation and a 35-year bear market in bonds that had lasted from 1946 to 1981. At the time, investors thought inflation would remain in the double digits for the foreseeable future. The bond trader above and others quoted in the same New York Times article also expected inflation to continue to rise, making even the newly-issued 15%-interest-rate Treasury bonds a bad investment.
In retrospect, that seems like an insane assumption. But, as New York Times financial columnist Floyd Norris wrote a little over a month ago, “A lot of people on Wall Street in 1981 could not remember a time when bonds were good investments.”
Of course, over the next 30 years, the bond market enjoyed a wonderful rally, and we now find ourselves in the opposite situation: everybody buys bonds, and yields are at rock bottom.
And unsurprisingly, Wall Streeters are now acting as if they can’t remember a time when bonds were bad investments. Or, as a Barclays banker quoted in Norris’ column said, “They say that fish don’t know that they live in water—until they are removed from it—and we wonder if some of the many market participants whose entire professional experience has been conditioned by the financial backdrop created by the bond market rally might underestimate some consequences of its termination.”
Luckily, you aren’t a fish. And hopefully, as a reader of Cabot Wealth Advisory, you’ve had the courage to take control of your investments, and thus have the power to abandon this outdated paradigm now, before the aquarium-dwelling bankers come to the same realization.
Of course, abandoning low-yielding bonds is probably going to leave a pretty big hole in your retirement account. And you’re going to want to fill it with something safe and income generating.
One solution, which many retired or retiring investors have already embraced, is to craft a personalized combination of dividend-paying stocks. The hundreds of dividend-paying stocks traded on major exchanges makes it easy it tailor a portfolio to your risk tolerance and income needs. Just take a foundation of 2%- and 3%-yielding blue chips and dividend aristocrats, add some undervalued stocks with historically high yields or dividend-growers to boost your yield in the future, and then top off with a sprinkling of riskier but higher-yielding investments.
For the best ongoing advice on creating a portfolio of dividend-paying stocks, I have to recommend my own newsletter, the Dick Davis Dividend Digest. If you take a trial subscription today, we’ll even start you off with a special report with 10 great candidates with a range of yields perfect for starting a layered income portfolio like I described above. Then every month, you’ll get 30 new ideas in the Dividend Digest. I highly recommend you try it.
Of course, I can still give you a few ideas here.
For the foundation of your safe income portfolio, you might consider replacing bonds with large-cap blue chip stocks that have low volatility and have paid dividends for many years. Something like Kellogg Company (K).
Kellogg was chosen as a Top Pick for 2013 in our latest Dividend Digest issue by Jim Stack, editor of InvesTech Market Analyst. He wrote:
“Kellogg Company (K), our top conservative idea for 2013, is the world’s leading producer of cereal and, with the May 31 acquisition of Pringles ($1.5 billion in sales), it became the world’s second-largest player in savory snacks. Founded in 1906, the company has become a global giant that maintains manufacturing facilities in 18 countries and sells its products in 180 countries.
“Although Kellogg is already arguably the best-known brand in breakfast products, the firm continues to focus on innovation and brand building, where it spends more, as a percentage of sales, than any other company in its peer group. Consequently, new products last year accounted for over $800 million in sales.
“Strategic acquisitions also provide an avenue to future growth. The recent Pringles addition tripled Kellogg’s international snacks operations and management recently stated that so far Pringles has exceeded expectations. The deal also opens avenues for the company to further expand its global platform.
“Despite this $2.7 billion acquisition, Kellogg’s finances remain on firm footing. The firm’s return-on-equity, which measures its profit generating efficiency, is greater than 50%, more than double the industry median of 23%. Expectations are that earnings will grow at a healthy 7% to 9% annual rate for the next three-to-five years.
“Also, this stock should be particularly attractive to conservative income-oriented investors as it offers an attractive 3.1% dividend yield, a dividend that has grown at an average rate of 7% annually over the last eight years. Moreover, as a member of the Consumer Staples sector, the stock is typically more resilient in the event of a market downturn.
“From a valuation standpoint, companies like this are rarely a bargain. However, Kellogg is currently selling at a Price-to-Sales ratio of 1.5, which is below its 10-year median of 1.7. This discount, together with the stimulus provided by the Pringles addition, should make Kellogg an attractive addition to any value-oriented portfolio.”
This year’s Top Picks issue also had some great ideas for the high-yield tier of your bond-replacement portfolio. For example, Ian Wyatt of High Yield Wealth chose as his Top Pick for 2013 a real estate investment trust, or REIT, that currently yields nearly 8% (plus, it pays dividends monthly). Here’s part of his recommendation:
“Income investors are plagued by low interest rates and a dearth of reliable income sources. For this, we can thank the Federal Reserve, which has wrung interest payments out of the fixed-income market. Fortunately, there is an investment that provides high-yield safe income: Gladstone Commercial Corporation (GOOD), a diversified commercial real estate investment trust.
“Gladstone Commercial owns 77 properties covering 21 states from Rhode Island to Texas. Gladstone’s portfolio is composed of commercial, industrial and retail properties. Moreover, 98.8% of its portfolio’s total square footage is occupied, and all tenants are current on their payments.
“As a REIT, Gladstone doesn’t pay income tax at the corporate level. This means more cash is distributed to investors. In fact, Gladstone’s $1.50-per-share annual distribution yields 8.5%—roughly four times the yield of the S&P 500. Gladstone’s average price-to-FFO (funds from operations) multiple of 11.5 is less than the industry average, but this is likely due to Gladstone’s small size and lack of institutional following. If the market yield were applied to Gladstone’s 2011 FFO of $1.53, you’d be looking at a $23.50 share price—a 30% increase to the current market price. In short, Gladstone is a value-priced, risk-averse REIT that is a model of high-yield dependable income.”
What do you think? Have you replaced bonds with dividend-paying stocks yet, or are you thinking about it? If you did, would your portfolio be full of more high-yielders like GOOD, or blue chips like K? Let me know by replying to this email.
Wishing you success in your investing and beyond,
Editor of Dick Davis Digests
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