After stunning first quarter returns (up 12%), stocks1 lost 3.3% in the second quarter, yet they remained up 8.3% for the year (through June 30). By comparison, first quarter client returns for our income/growth strategy were 2.03%, and second quarter returns were 1.80%, for a year-to-date performance of 3.85% as of 06/30/2012.2 I find the year-to-date stock performance impressive, given the barrage of bad news coming out of Europe and the Middle East. The United States remains a (relatively) safe haven for investors. The recent pullback in stocks created some buying opportunities, but macroeconomic downside risks remain.
On March 31, 2012, 10-year U.S. Treasury note yields were 2.21%; by July 16 yields had dropped to 1.45%. Similarly, 30-year U.S. Treasury bond yields were 3.34% on March 31, but by July 16 had dropped to below 2.5%. Bad news for the economy has been good news for bond prices (bond prices increase as yields decline). Treasury bonds have been increasing in price on increasing demand from global investors selling risky investments to buy “safer” ones. The slowing of the U.S. economy also contributed to higher demand for U.S. Treasury bonds.
Meanwhile, municipal bonds (munis) were marching to a somewhat different drummer. Many municipalities sold bonds during the quarter, and the increased supply weighed bond prices down. Dealers/underwriters often wound up with balances on deals they couldn’t completely sell. On the demand side, municipal bond buyers were reluctant to buy as yields declined to levels unprecedented in their lifetimes. Considering the likelihood that tax rates will increase, tax-free bonds should be enjoying greater demand from investors.
Today’s bond market is highly unusual in that despite the relatively low yields of tax-free bonds, the yields are still significantly higher than federally taxable U.S. Treasury bonds. As you can see in the chart above, the normal relationship has been inverted — the blue line (munis) should be below the green line (Treasuries), but it’s not. A situation like this is rare and would normally indicate good value for munis — if only things were “normal.”
Comparison of Current Yields for Municipal Bonds and Treasury Bonds
The blue line (munis) would typically be below the green line(Treasuries); the current inversion is rare.
(The vertical line denotes the bond’s interest rate, and the horizontal line denotes the bond’s maturity.)
I have never seen a more challenging environment when it comes to finding relatively safe yield, and I am not alone.
As always, Wall Street has responded by encouraging investors with various “safe” income strategies. The table below lists some of their offerings — and my reasons for avoiding them. Exceptions are always possible, but skepticism and careful analysis are warranted before investing.
Cautions Against Popular Income Strategies
In June, I attended a hedge fund/family office conference in Florida. As a result of a meeting there, we are now engaged in due diligence to evaluate a 20-year-old California company that makes short-term first trust deed–secured loans to real estate investors purchasing single family homes as rentals. If this appears attractive and the company checks out, we may offer this to clients who meet SEC Regulation D requirements and can be adequately diversified after a yet-to-be determined minimum investment. The company uses investor money to fund its loan portfolio that now has an average maturity of less than one year and yields 7–8% to investors. Borrowers pay points on the loan, which the company keeps.
Whether we ultimately recommend the above investment or not, the message I would like clients to take away is that I recognize that protecting and earning a reasonable return on our savings will take more work than ever, and that investment alternatives not previously considered may need to be examined. Should I find an attractive alternative, I will be using the purchasing power of my client base to get us the best terms possible.
1. S&P 500 Total Return Index, which includes the reinvestment of dividend income. 2. MCS portfolio returns are dollar-weighted, net of investment management fees, include reinvestment of dividends and capital gains, and represent all fully discretionary income/growth accounts. These accounts represented 92% of MCS Financial Advisors’ assets under management as of 6/30/2012 and were invested primarily in U.S. stocks and bonds (21% of the income/growth assets on 6/30/2012 were invested in tax-exempt municipal bonds). There is no guarantee that prior performance will continue in the future, nor that any statement of opinion herein has value beyond the date of this publication. Bond performance does not include the effect of state or federal taxes. The S&P 500 Total Return Index measures the large-capitalization U.S. equity market, and the Barclays Capital U.S. Aggregate Bond Index measures the U.S. investment-grade bond market. Index values are for comparison purposes only.