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How to maximize what your cash pays even when nothing is paying much of anything now
03/05/2010 8:30 am EST
Maybe you’d love to invest it, but where?
The stock market seems pricy after a 70% rally from the March 2009 lows. And it’s been so up and down lately that it doesn’t inspire much confidence. So maybe stocks are just too risky for you. Or you’re close to retirement or those college tuition payments and can’t take a risk. Maybe you’d just like to wait. Or maybe you just need more income than most stocks pay these days.
Bonds are, well, no bargain. A three month Treasury bill pays just 0.12%. A two-year note pays just 0.79%. Inflation may not be very high at an annual rate of 2.6% for headline inflation (and 1.6% minus volatile energy and food prices) but it’s enough to eat up all the interest from those investments and more. (TIPS, Treasury Inflation-Protected Securities will protect you from inflation but the yields are really low (1.43% for a 10-year TIPS at recent auction) and they only protect you from inflation and not rising interest rates. I-Bonds, a savings bond that pays an interest rate that combines a fixed component, currently 0.3%, with an inflation-adjusted variable rate, current 3.06%, offer a higher yield but since the variable rate is pegged to inflation and not interest rates, the yield on these bonds won't neceesarily go up if interest rates do. You also have to hold for at least 12 months. (After that and until you've held for 5 years you lose the last 3-months of interest when you sell.)
You could lock your money up for decades and get 4.56% in a 30-year Treasury bond but 30 years is forever. And besides interest rates have to go up from today’s lows and that means bond prices will be coming down, probably fast enough to eat up all the interest that bond pays and more.
A certificate of deposit (CD) would make sure you get your invested capital back intact but the highest rates I can find for a one-year CD are 1.88% (at Eastbank) and 1.7% (at Tennessee Commerce Bank). That doesn’t even beat headline inflation.
Might as well keep it buried in the back yard—except that loses out to inflation too.
Here’s my advice: Think short term. It’s the best way right now to maximize long-term income.
Not if you remember that interest rates are going up in most of the world (except maybe Europe and Japan) quite dramatically over the next 12 months. A year from now, perhaps sooner, you’ll be able to get yields swell north of anything you can find now.
That pretty much means that you’re guaranteed to lose money two ways by locking it up for the long term now.
You’ll lose money, first, because that 30-year Treasury with its 4.5% coupon rate of interest will look pretty pathetic if 30-year bonds are paying 6% in a year. $10,000 invested in a bond paying 4.5% throws off $450 in interest in a year. At 6% all it takes is $7500 invested in a bond to produce the same $450 in cash. Interested in exploring the misery of watching a “safe” bond lose 25% of its value in a year?
And you’ll lose money, second, because every dollar that you’ve got locked up at today’s low interest rates is one less dollar that you can put to work at tomorrow’s higher rates. Your portfolio will thank you and your household cash flow will thank you for avoiding as much of this opportunity cost as possible.
So how do you go about1) thinking short term in order to 2) maximize long-term income?
For the short term you need to put your cash into something that’s as safe as possible but that offers you as much income as possible—and that doesn’t lock up your money for very long.
My choice dividend paying stocks—if they pay a high dividend, are extremely liquid, and are battle tested. Let me use chemical maker E.I. du Pont de Nemours (DD) to show you why.
Here’s a stock that’s paying a dividend of 4.86%. That’s more than you’ll get from even a 30-year Treasury at the moment.
The shares are very liquid so you should have no trouble trading in and out when you need to. Average daily volume is more than 7 million shares traded and the company has issued 904 million shares.
And the dividend has been battle tested in the Great Recession. The annual dividend was $1.46 in 2005, $1.48 in 2006, $1.52 in 2007, $1.64 in 2008, and, most impressively, $1.64 in 2009. If du Pont didn’t cut its dividend in 2009, I think it’s pretty safe unless the economy is hit by something worse than the great depression.
Dividend stocks like du Pont also give you another kind of protection. If interest rates rise faster than anyone now expects, it will (short of a meltdown in U.S. finances, which is unlikely in the short-term) be the result of faster than expected economic growth triggering faster than now anticipated interest rate increases from the Federal Reserve. If that happens, a company like du Pont will see its revenues and earnings go up faster than is now anticipated. That should more than make up for any downward pressure on the stock price because the dividend no longer seems quite so juicy. (For what to worry about in 2010 see my post http://jubakpicks.com/2010/02/16/how-to-worry-and-when-in-2010/ .
That’s exactly what happened in 2009 as the stock market began to anticipate an economic recovery in 2009. The yield dropped from 6.48% at the end of 2008 to 4.87% at the end of 2009. But the stock’s price soared 40%.
Of course, if the opposite happens and the economy tanks again, the stock price will go down for the duration of the slump, but you will still be collecting your 4.86% dividend.
You can find some other stocks that fit this profile such as American Electric Power (AEP), Potlatch (PCH), and Verizon (VZ) on my Dividend Income Portfolio http://jubakpicks.com/
Okay, now let’s look at where you might be able to find the highest yields in the long run.
My bet here is the world’s emerging markets.
The odds are that countries like Brazil, India, Turkey, and even Mexico are much closer to the beginning of a series of interest rate increases than any of the developed economies are. Economic growth in these countries is already so strong that central banks there are seriously worried about inflation. It’s not a question of when they start raising interest rates but how quickly they do. And for how long.
For example, the forward futures market is pricing in an increase in interest rates in Brazil to 11.5% by the end of the year. That would be a 2.56 percentage point increase.
The futures markets are pricing in an increase of 1.86 percentage points to 9.05% in Turkey. And in India an increase of 1.19 percentage points to 4.66%.
Higher interest rates, if they work they way that central banks would like them to, would slow these economies but growth should still be stronger than in the European Union, Japan, or the U.S. and that should keep stock markets in these countries rising. Higher interest rates will push local currencies such as the Brazilian real higher against the euro and the dollar and that will offer additional profits and protection to European Union and U.S. investors.
You can execute this long-term strategy by buying stocks in emerging markets as long as you stick to utility and utility like stocks. Companies that need to raise capital frequently will try to keep their dividend yield in line with interest rates so they can compete with bonds to raise capital. Three to consider are Telkom Indonesia (TLK), a member of my Dividend Income Portfolio, and Philippine Long Distance (PHI) and Turkcell Iletisim (TKC). The latter two are both on my Jim’s Watch List http://jubakpicks.com/ .
I’d say buying emerging market bonds would be an even better strategy toward the end of the year—if you can find an ETF or close-end emerging market bond fund that—ideally-- 1) buys bonds denominated in local currencies, and 2) focuses on the right mix of markets.
That’s because buying emerging market debt directly can be just too hard and expensive for individual investors. I’m going to test exactly how difficult it is for individual investors to buy the bonds of big emerging market companies that issue lots of debt such as AmBev (ABV) and Vale (VALE) in Brazil and Cemex (CX) in Mexico. I’ll report back on what I find here.
In the meantime, although I haven’t found any that exactly match what I’m looking for, I’d certainly take a look at the closed-end funds (remember you want to buy closed-end funds at a discount to net asset value) AllianceBernstein Global High Income Fund (AWF) and Morgan Stanley Emerging Markets Debt (MSD), and among mutual funds MFS Emerging Markets Debt (MEDEX) and Fidelity New Markets Income (FNMX). Among ETFs (exchange traded funds) take a look at iShares JP Morgan USD Emerging Markets Bond Performance (EMB).
You’ve got time to research these choices: Remember that you want to buy them after emerging market interest rates have moved up some.
Full disclosure: I own shares of AmBev, Telkom Indonesia, and Vale in my personal portfolio.
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