I think the argument that we're in an income asset bubble is easy to make--deciding when it might burst and what to do about it are much harder
11/23/2012 8:30 am EST
Money continues to pour into the government bonds of the United States, Japan, Germany and other “safe haven” countries even though yields there are negative after inflation and even though some of these “safe havens” rank among the world’s most indebted governments.
Dividend stocks too have risen to historic highs even as yields have dipped. For example, an index that tracks the Standard & Poor’s “dividend aristocrats,” a basket of 51 stocks that have increased their dividends annually for at least 25 years, hit an all-time high in October.
We all understand the reasons behind this love affair with income assets. Stocks have been scarily volatile for the last decade or more—and threaten to become even more so. The world’s central banks have flooded financial markets with cash, crushing yields, but at the same time promising to keep interest rates extraordinarily low for an extended period, in the formulation of the U.S. Federal Reserve. A sputtering global economy has resulted in low rates of inflation and frequently, in fact, deflation seems a more immediate threat than inflation.
But we know that we’re nearing the end of this cycle. The yield on two-year Treasury notes could drop below the current 0.24%--that’s a negative 1.96% yield at recent U.S. inflation rates—but the yield is unlikely to go below zero. At some point—mid-2015 in the Federal Reserve’s most recent formulation—the world’s central banks will start raising interest rates again. A return to global growth or simple demographic pressures or the aging of the world’s population will lead to higher rates of inflation.
And we all know the big important questions too: When? And What? Knowing what we know—about the likelihood of a bubble and the eventual breaking of that bubble—When do we take action to avoid getting caught up in the bursting of that bubble? And when we take action What do we do?
We’re all friends here so let’s be frank: Everyone investing in the markets for income assets believes that they will be able to see the breaking of the bubble with enough lead time to exit the markets.
Of course, financial history says that won’t be true. Financial logic, indeed, says it can’t be true unless you’re willing to believe that you will be able to see the bursting of the bubble before everyone else does. If everyone sees it at once, we’re looking at a mad panic at the exit doors. If just a large chunk of the market sees it coming, we’re looking at the kind of move to the exits that actually accelerates the bursting of the bubble.
Moreover, timing the breaking of this bubble seems especially problematic.
Start with the Fed’s deadline of keeping short-term interest rates near 0% until mid-2015. Of course, that only refers to the short-term interest rates where the Fed exercises something like direct control. Long-term rates could well move up—hurting bonds and other income assets—before that if investors see inflation or signs of future inflation or come to expect future inflation. (Throw in the wildcard here of the Fed’s program of quantitative easing and its buying, under that program, of longer-term assets.) And, of course, anybody knowing that the Fed’s pledge is scheduled to expire in mid-2015 will decide to sell before that date. That leaves income investors trying to decide when other income investors will decide that it’s time to sell. Sounds exactly like John Maynard Keynes lament that to pick the winner of a beauty contest (or winners in the stock market), you have to pick not the most beautiful face but the face that you think the other judges will think most beautiful. “It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees,” Keynes wrote way back in 1936.
That judgment is complicated by the difficulty of predicting major supply and demand trends in the income market—and the effect of those trends on the price of income assets. Right now, for example, because the Fed is buying assets for its program of quantitative easing there’s a shortage of new supply of Treasuries, government-backed assets, and investment grade corporate bonds. Supply in those categories, in high demand from risk-averse investors, is forecast to go up by $1.16 trillion in 2013, according to RBS. But the Fed is projected to buy $1.02 trillion of that supply, leaving just $138 billion for investors. On the other hand, if 2013 or 2014 saw some solution to the euro debt crisis, the demand for “safe haven” assets would drop and offerings from more governments might qualify as safe havens.
Frankly, as unsatisfactory as it may be as an answer, I think income investors who want to know When? can’t do much better than watching inflation and inflation projections (to judge inflation expectations) and the direction of central bank policy. A switch from the current aggressively loose monetary policies at the Fed, the European Central Bank, and the Bank of Japan to something like neutral would be a key indicator of a change in the weather.
But maybe the most important conclusion to be drawn from trying to forecast When? and discovering the difficulties in that quest actually falls into the What? category. If deciding when the turn will come is so difficult and the likelihood of calling that turn correctly is so is modest, then the last thing an investor would want to be doing now is reaching for yield by piling on risk. You can see the potential punishment in going for yield by adding risk in the junk bond market over the last month or two. Average junk bond yields hit a record low of 6.14% in September as investors hungry for yield drove up the price of junk bonds. Yields, however, had climbed back to 6.85% on November 19 as investors decided to sell this asset class to reduce the risk in their income portfolios. That rise in yield is a result of a decline in the price of junk bonds so right now junk bond investors who bought when yields were 6.14% and prices high are looking at a 10.4% hit to their capital.
Does that mean income investors should resign themselves to low yields like the safe 1.65% offered by 10-year Treasuries right now? That seems almost as unattractive as an alternative as loading up on risky income assets. Since investors can’t predict the When? of the turn, they could wind up stuck with a 1.65% yield for quite a long while.
I think the solution is to get opportunistic and creative.
In this very volatile market, individual income offerings will get temporarily mis-priced by nervous investors. Forget about allocations to entire income asset classes. Jump on those mis-priced assets one by one.
For example, units of Targa Resources Partners (NGLS) took a pounding from $42.83 on November 6 to $35.96 on November 16 on news that the company would price a secondary stock offering at just $36 a unit. It’s typical for secondaries to get priced below the current market in order to attract new money. But in this case the pricing seems to have been aggressively low and that took down Targa. After all if you can buy the secondary at $36, why pay $42 for units on the market?
What makes this drop a very interesting opportunity is that the capital raised is going to finance an acquisition that takes this pipeline master limited partnership (MLP) into North Dakota’s Bakken shale formation. (For more on this fast-growing oil producing geology see my post http://jubakpicks.com// .) Targa is buying Saddle Butte Pipeline’s crude oil pipelines and natural gas gathering and processing operations in the Williston Basin for $950 million. The growth potential here is very solid—not only is oil and gas production climbing in North Dakota but also the region is underserved by pipelines with 74% of North Dakota crude traveling by (more expensive) truck. Targa, which already operates in the Barnett and Wolf Camp areas in Texas’s Permian Basin and in Louisiana’s Tuscaloosa play, raised its target for 2013 adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) by 10% to 15% and kept its projections for distribution growth for 2013 over 2012 at 10% to 12%.
Because of the sell off on the secondary, Targa Resources currently trades with a yield of 7.2%. I don’t see a level of risk in domestic energy pipeline partnerships to make me shy away from that yield. At the moment I think Targa is simply mis-priced. I’m adding it to my Jubak’s Picks portfolio http://jubakpicks.com/ today.
That’s an example of being opportunistic. Here’s an example of being creative.
Some of the most interesting interest rate plays right now are stocks that don’t pay any dividends—as contradictory as that might seem. Highly leveraged companies with big bills for interest payments are re-structuring their own balance sheets to bring down the cost of their borrowings. That lower cost falls straight to the bottom line. By buying the stock of one of these companies you don’t get any actual income, it’s true, but you do get the benefit of low interest rates.
The most interesting plays like this are in countries were improving economies and government economic policies are bringing down overall interest rates in the market. (Brazil is a good example of this.) And this is especially the case in countries such as Colombia and Mexico that are being rewarded for sound governance by upgrades to their sovereign credit ratings. In Brazil take a look at Hypermarkets (HYPE3.BZ in Sao Paulo), the country’s largest consumer health company, which in July refinanced bonds that had paid 113.72% of the interbank rate at 105%, or food processor Marfrig Alimentos (MRFG3.BZ in Sao Paulo), which just raised $543 million in a stock offering to pay down pricy debt. In Mexico look at home builder Urbi Desarrollos (URBI.MM in Mexico City) and global cement maker CEMEX (CX in New York), which are both restructuring debt and lowering interest payments.
I think it’s too early to give up on income assets—but it is certainly time to work harder at finding the opportunities that this market still does offer. We’re close enough to the turn in this income asset rally that you can’t just buy assets by the bucket full anymore.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund owned shares of Urbi Desarrollos at the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/