It is the best of times and the worst of times. It’s a tale of two markets.
Investing for income has never been so expensive. But even with major stock indexes at records, equity investments are as inexpensive as they were dear during the days of “irrational exuberance” late in the last century.
Pity the poor income investor. On Thursday, the Treasury auctioned 30-year bonds at the lowest yield in U.S. history, 2.061%. On the same day, the yield on 10-year Greek bonds dipped below 1%—a far cry from the 44% peak reached at the height of Athens’ debt crisis in 2012 and the more-than 4% seen as recently as early 2019. Such a low return from a borrower lacking investment-grade credentials can be explained only in a world of $13 trillion of negative-yielding debt, including benchmark German Bunds at minus 0.38%.
The collapse in yields means that massively more bucks are needed to generate the income to which American individual investors have become accustomed. According to UBS, four decades ago, a $5 million portfolio of municipal bonds would have generated a tax-exempt $500,000 annually. Today, it takes $30 million to produce that $500,000. For the rest of us, who don’t happen to have $30 mil, the collapse in bond yields means a pay cut.
Conversely, an analysis by Capital Economics’ John Higgins indicates that stocks are a comparative bargain, even with the Dow (.DJI) closing in on 30,000. Based on relative valuations, equities are much more attractive now than they were unattractive back in 1997, not long after former Federal Reserve Chairman Alan Greenspan famously wondered about investors’ mind-set.
That year, the central bank’s semiannual report to Congress compared the yield on the benchmark 10-year Treasury note with the forward earnings yield on the S&P 500 index (.SPX), a relationship that came to be known as the “Fed Model.” (The earnings yield is calculated by dividing S&P share earnings by the index; in other words, the reciprocal of the more familiar price/earnings ratio.)
At the time, the S&P earnings yield was 90 basis points (0.9 of a percentage point) less than the Treasury yield, the smallest gap since 1991. Previously, the two numbers had tracked each other closely for years. Thus, by that criterion, it appeared that stocks were overvalued. Now, the S&P earnings yield of 5.4% is far above the 10-year note’s 1.60%, making stocks much more alluring.
Determining whether equities are overvalued depends not so much on absolute yields, but on how far they have strayed from their equilibrium, Higgins concludes. He reckons that the equilibrium federal-funds rate (the Federal Reserve’s main policy target) and the extra return that investors demand for the risk of holding equities both have declined since 1997. According to Higgins’ estimates, the equilibrium S&P earnings yield is 4%, below the current 5.4%, based on forward earnings. This reflects the “exceptionally loose monetary policy” since the last recession.
In the meantime, income-starved investors still want stocks that show them the money via dividends. Energy shares appear to offer both income and rock-bottom valuations, as our colleague Andrew Bary reported last week. The big oil majors provide yields ranging from 4.7% to 7.2%.
One alternative to individual oil stocks—or the Energy Select Sector SPDR exchange-traded fund (XLE)—is the closed-end Adams Natural Resources fund (PEO). The unleveraged CEF trades at a 10.87% discount to its net asset value, with heavy weightings in Exxon Mobil (XOM) and Chevron (CVX), similar to the XLE’s. Adams Natural Resources “is committed to an annual distribution rate of 6%,” according to its website. Its expense ratio also is lower than most closed-end funds’, at 0.56%.
At the same time, the long-lagging energy group is showing signs of bottoming. That’s the view of J.P. Morgan technical strategists Jason Hunter and Alix Tepper Floman. From 2008 to 2020, the group has given back all of its outperformance of 1998 to 2008. That shift syncs with the long-term rotation to growth from value stocks and the flattening of global yield curves, an indication of less stimulative monetary policies.
From a fundamental point of view, the relative performance of the energy group has correlated with Chinese industrial production, they continue. With the coronavirus crisis, not surprisingly, the stocks have been making new lows. But the decline shows signs of decelerating, despite the barrage of headlines about the virus. A tenet of technical analysis is that changes in momentum tend to lead prices.
For investors who still want bonds in their investment mix, taxable municipals offer yields competitive with those of corporates, plus higher credit quality, according to a UBS client note. The Invesco Taxable Municipal Bond ETF (BAB) yields 2.7% and has a duration of 9.6 years, comparable to that of the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD). (Duration measures a bond’s price sensitivity to yield changes.) But the taxable muni ETF has an average credit rating around AA, with 6% of its holdings in BBBs. The corporate ETF’s average rating is about A, with 49% in BBBs.
Higher yields are available in leveraged taxable muni CEFs, including Nuveen Taxable Municipal Income (NBB), at 4.94%, and BlackRock Taxable Municipal Bond Trust (BBN), at 5.29%. That compares with 5.02% on the iShares iBoxx $ High Yield Corporate Bond ETF (HYG).
This might be an age of wisdom or an age of foolishness. Either way, generating income is a dickens of a task.
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