Finding Income

Looking for Safety and Income

Bonds, REITs, ETFs and Stocks

SPDR S&P Dividend ETF

Bonds Bears

 Bond prices have been declining steadily during the past five months, and given that bonds tend to move in very long-term cycles, prices could easily fall further in the months ahead. The recent bond bull market started 32 years ago in 1981 when the interest rate on the 10-year U.S. Treasury Bond was a whopping 15.8%.

Are we headed into a new bear market in bonds? In my opinion, yes. The interest rate on the 10-year Treasury has risen from 1.4% in July of 2012 to 2.6% now. As you can see on the 10-year U.S. Treasury yield chart below (with yield data from 1949 to the present), the recent 1.2% jump in interest rates is not unusual. The surprising fact is that the low 1.4% yield seen last year is the lowest since the 10-year bond was first offered in 1912!

Keep in mind, as interest rates rise, bond prices fall. And if the yield on the 10-year bond rises to its 101-year average yield of 6.4%, most bond prices will decline noticeably. Ironically, the reason for my bearish bond forecast is precipitated by several positive economic trends in the U.S.: growing confidence that the economic recovery, though slow, is sound; favorable trends in the job market; the strong rebound in the housing market; and the vigorous rise in the stock market. Based on the past, when economic factors improve, interest rates rise and bond prices fall. 

Bond Laddering 

First, I do not like bond mutual funds or bond exchange traded funds (ETFs). If bond prices continue to decline during the next several years (or decades), most bond funds and ETFs will also fall. However, there is a way to make money in the bond market.

Most investors are familiar with bond laddering. Just to quickly review, you can buy bonds with various expiration dates. The bond issuer will pay you the full principal amount of your bond when it expires.

I advise investing in one-year, two-year, three-year, four-year and five-year bonds. A five-year ladder works best when interest rates are rising. The interest yields won’t be great, but your yields will increase with each passing year.

When your one-year bond matures a year from now, your four other bonds will each be a year closer to maturity. Each year, you’ll replace the maturing bond with a new five-year bond—thus keeping your ladder intact.

Best Bond Bets
Current yields on U.S. Treasury bonds and notes are low, but the safety of owning U.S. Treasuries will put your mind at ease. You might also consider municipal bonds in your ladder. Munis, as they are often called, are available at reasonable prices.

Muni prices declined when Detroit filed for bankruptcy. Tax-free municipal bonds with good quality ratings and backed by general tax revenues are now priced to yield more than Treasuries of the same maturity. If needed, you should contact your broker to get help choosing the right munis for your five-year ladder.

If you want higher yields, consider lower quality corporate bonds, but not low-quality “junk” bonds. Lower quality corporate bonds rarely default during an economic expansion and provide considerably higher yields than municipal or Treasury bonds. Again, contact your broker to find bonds that will fit your objectives.

Real Estate Investment Trusts (REITs)

REITs can be good sources of income, but real estate cycles are unpredictable. When the economy expands, most REIT incomes will rise as vacancies decline, but rising interest rates will slow growth for many REITs. The prices of REITs have rebounded nicely since the 2008 financial crisis and are therefore becoming more overvalued and less attractive than two years ago.

Common Stocks and ETFs

I have counseled my Cabot Benjamin Graham Value Investor subscribers to sell their bond funds and bond ETFs and invest in safe, high-quality, dividend-paying stocks and ETFs. Currently, companies paying dividends yielding 2% to 3% are being neglected by investors. Bargains can be found in high-quality companies paying dividends yielding more than high-quality bonds. Also, the companies have real prospects for growth, as opposed to bonds, which pay a fixed coupon.

The best stocks and ETFs include those that boost their dividends every year without fail. When you invest in companies that regularly raise dividends, you can add more shares while you hold, collect a rising stream of income, and continue to hold unless the company fails to increase the dividend during any year.

Many companies are committed to raising their dividends every year. Standard & Poor’s maintains an index called the “Dividend Aristocrats.” To make the list, companies must increase their dividends for 25 straight years. The 54 companies that are currently included in the Dividend Aristocrats Index strive to stay on the list, while many other companies work toward joining this elite group.

I have generated a list of 22 companies which have increased dividends every year during the past 15 to 24 years. Future sales and earnings growth will enable these companies to increase their dividends faster than the 54 companies in the Dividend Aristocrats Index. Soon, many of the 22 companies will qualify for the Index and receive lots of attention. If you would like a free copy of my list (no strings attached), simply reply to this email and request your copy.

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My favorite income producing investment is an ETF with a dividend yield of 2.6%. It’s the SPDR S&P Dividend ETF (SDY: Current Price 66.91; Minimum Sell Price 103.00), which holds all the companies in the S&P 1500 Index that have raised their dividends every year for the past 20 years. The objective of SDY is to include companies that have increased their dividends consistently. Only 85 companies qualify!

Companies with pristine dividend records tend to produce solid earnings and sustainable business models. Also, management is less likely to engage in reckless capital spending if one of the goals of management is to protect and grow the company’s dividend.

SDY is currently selling right at its net asset value. The P/E ratio, based on current EPS, of the stocks contained in the ETF is 19.1, and the price-to-book ratio is 2.74. Both ratios are reasonable, and the beta is below average at 0.77. Management fees total 0.35%.

SDY is quite well diversified with risk spread over 85 holdings. The largest position consumes only 2.70% of the total portfolio. The six largest holdings in order of size are AT&T, HCP, AbbVie, Consolidated Edison, Nucor and National Retail Properties.

The five largest sectors are Consumer Staples, Financial Services, Industrials, Materials and Utilities. SDY is a great substitution for bonds because of its 2.6% yield and steady performance. I expect SDY shares to reach my Min Sell Price of 103.00 within two years.

I will continue to follow SDY, as well as many other undervalued, high-quality companies and ETFs in my Cabot Benjamin Graham Value Investor. Earlier this month, I simplified my Investor format to make it easier for you to invest and instantly reap bigger profits and dividends. If you subscribe now, you will receive my October publication on Thursday, October 3!

Until next time, be kind and friendly to everyone you meet.

Sincerely,

J.Royden Ward
Editor of Cabot Benjamin Graham Value Investor

Editor’s Note: You can find additional dividend-paying, high-performing stocks selling at bargain prices in the Cabot Benjamin Graham Value Investor. In every issue, you’ll find my legendary Maximum Buy and Minimum Sell Prices for over 275 stocks.

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