Ready to lock up money for 54 years at just 3.4 percent annual interest? More than a few investors did this week when their funds bought Enterprise Products Partners’ (NYSE: EPD) 7.034 percent bonds maturing January 15, 2068, a barely investment grade BBB- credit.
Traders have knocked prices of benchmark Treasury paper for a loop in recent months, in anticipation the Federal Reserve would “taper” its bond purchases. And with the central bank finally setting a timetable for action this week, the 10-year yield has risen to within a stone’s throw from 3 percent.
The Fed initially floated the idea of tapering this spring, stating it would consider such action once it saw sufficient strength in the economy. The recent drop in the unemployment rate to 7 percent and the deal on the Federal Budget appear to have convinced the outgoing Chairman Ben Bernanke and his putative successor Janet Yellen that now is the time to begin taking action.
Tapering, however, has been priced into the market for some time. In fact, the jump in the 10-year Treasury note yield arguably prices in a lot more, i.e. the end of the bond-buying program entirely, if not of easy money altogether.
As a result, there was very little selling of Treasury paper following the actual tapering announcement this week. And with inflation still below the Fed’s target of 2 percent, it’s likely to take a lot more than we’ve seen so far to trigger a further meaningful selloff.
Since May, the deeply entrenched conventional wisdom has been that eventual Fed tapering would doom all things income. But despite volatility, dividend-paying stocks are headed for another winning year in 2013, with the Alerian MLP Index and Dow Jones Utility Average showing double-digit total returns with less than two weeks left.
That should be no surprise to anyone who has studied the long-term relationship between dividend stocks and interest rates. Simply, stocks are stocks, whether they pay dividends are not. And dividend-paying stocks respond to the same external factors other stocks do. That’s the strength of the economy, which often moves inversely to interest rates.
The benchmark 10-year Treasury note yield jumped even faster and higher in 2009, for example. But that was one of the best years ever to own dividend payers. Conversely, the year before (2008), interest rates plummeted in the wake of the most severe economic/credit crunch since the 1930s, and dividend-paying stocks crashed along with the rest of the stock market.
The strength of the corporate bond market in the face of tapering, however, is quite extraordinary. In fact, as the rally in Enterprise’s debt makes crystal clear, it’s still very much a seller’s market for bonds.
Begging for Bonds
Many of the biggest institutions dominating the market today must constantly buy bonds to fill their portfolios. And after four years with interest rates at multi-generational lows, corporations have been able to structure balance sheets to maximize flexibility issuing new debt.
The upshot is that corporate issuers can pick and choose their spots to take advantage of favorable conditions for selling. Bond buyers, on the other hand, are often forced to pay up for what’s available. And Federal Reserve tapering has thus far done little or nothing to alter that imbalance.
Among the most popular investment vehicles here in late 2013 are Vanguard Target Retirement Funds. I’ve recommended many managed Vanguard mutual funds in the past, including a municipal bond offering featured in the current issue of Capitalist Times.
Vanguard funds’ chief appeal is ultra-low expenses, which enable them to produce competitive returns without taking the risks their higher expense rivals are forced to. Their bond funds won’t make you rich. But they’re usually the least risk alternatives in the sector, which looms large at a time when bond market valuations are arguably at or near all-time highs.
The concept of Vanguard Target Retirement Funds is they provide a complete portfolio into a single investment. The holdings are the Vanguard family’s broadest stock and bond index funds, which give investors a piece of literally thousands of individual stocks and bonds.
Such massive diversification is about as close as you can come to eliminating “unique” stock market risk, or the risk of a single holding blowing up.
Market risk, meanwhile, is controlled by a locked-in formula of sector and asset allocation, which essentially shifts the portfolio toward bonds as the target retirement date for the fund approaches. Returns are further enhanced by low fund expenses, which average just 0.17 percent for the group.
Vanguard literally offers Target Retirement funds for every age group, starting for investors of 18-20 and continuing through 65 years. As of the end of November, the fund with a target date of 2055 was roughly 90 percent stock index funds and 10 percent in bond index funds. The Target 2015 fund, in contrast, has 55 percent stocks and 45 percent bonds.
The Target Retirement Funds shift holdings to achieve these allocations among the following Vanguard index funds:
Vanguard Total Stock Market Index Fund Investor Shares
Vanguard Total International Stock Index Fund Investor Shares
Vanguard Total Bond Market II Index Fund Investor Shares
Vanguard Total International Bond Index Fund Investor Shares
Vanguard Short-Term Inflation Protected Securities Index Fund I.S.
The idea is to essentially put investors’ portfolios on autopilot, eliminating the destructive impact of emotions. Returns are by no means guaranteed. But they will follow the performance of broad markets over time. And that holds immense appeal at a time when many individual investors doubt their ability to manage their own affairs.
As they’re relatively new, the Vanguard Target Retirement Funds have yet to prove themselves over a meaningful length of time. But the strategy itself basically mirrors that of products Wall Street houses have traditionally marketed at a much higher cost.
One drawback is these funds’ component parts will never outperform the indexes they represent. There are also serious questions about whether the balancing strategy really reduces risk as the retirement target date nears. In fact, today’s high bond prices arguably mean the strategy increases risk as the target date approaches.
In any case, the popularity of these and like funds at other families has for now locked in rising demand for the bonds held by index funds. Ultra-liquid US Treasury paper can be traded to reflect changing expectations for interest rates. Individual corporate bonds, however, are not issued in such hefty quantities. And the more these index funds grow, the further demand for what’s inside them will outweigh supply.
Just a few months ago, for example, Verizon Communications’ (NYSE: VZ) issued a record $49 billion in new bonds. The purpose was to finance its $130 billion purchase of Vodafone Plc’s (London: VOD, NYSE: VOD) 45 percent stake in Verizon Wireless.
The size of that deal was roughly twice management’s initial projection, reflecting robust demand from investors. And the company was able to also heavily weight the offering to longer-dated paper, and at a minimal discount to prevailing interest rates.
Moreover, slightly more than three months later, the longest dated bond of that tranche—the 6.55 Percent Bond of September 15, 2043—is selling for 17 percent above the issue price, or par value. And other Verizon bonds from the sale have scored similar gains.
Demand for junk or non-investment grade bonds also remains as robust as it’s been in years. BB-rated Energy Transfer Equity (NYSE: ETE), for example, upsized an offering of 10-year bonds from $400 to $500 million in mid-November at a coupon rate of just 5.875 percent. That issue has already rewarded investors with a gain, even as the 10-year Treasury note has sold off sharply.
Many municipal bonds and related investment funds have lost ground in recent months. That’s, however, also a reaction to credit concerns in the wake of Detroit’s Chapter 9 filing, and worries about a potentially even worse crisis brewing in cash-strapped Puerto Rico. Demand for high quality paper remains robust.
In the End, Stocks
What could cool off this sellers’ market in corporate and other bonds? It’s certainly not Federal Reserve tapering, unless central bank actions become a lot more dramatic.
Rather, the most likely catalyst is a shift in investor attitudes that favors stocks. A range of concerns, including doubts about US government stability, has occasionally interrupted the stock bull market that began in March 2009. But the past four years plus have nonetheless been one of the most explosive and rewarding times in history to own stocks.
The good news for stocks is the market is still climbing the proverbial wall of worry. Investment newsletter promotions touting the end of America remain a popular draw. Pessimistic and emotional commentary dominates the radio and television airwaves as well. Gold’s crash to its lowest price since August 2010 hasn’t muted its advocates. And despite the recent titanic decline of virtual currency bitcoin, seekers of alternatives to the US dollar remain undaunted.
The wall of worry is an essential element to continued stock market gains in 2014. Sooner or later, however, the consensus will become that the best of the bull market is year ahead.
At that point, we’ll be pretty close to the end of the bull market. But before that happens, the appeal of bond-focused investments will decline sharply. That will reduce demand for index fund vehicles like the Vanguard Target Retirement funds. In fact, mediocre recent returns for many of the Target Retirement funds—due to in large part to hefty bond holdings—may already be dimming their appeal.
The good news is, so long as borrowing costs are this low, dividend-paying companies will be able to continue locking in low-cost money, strengthening balance sheets and putting the elements for growth in place. And when faster economic growth does come, they’ll enjoy the benefit from higher earnings, dividends and share prices.
That’s another reason why I prefer dividend-paying stocks of strong companies to almost anything in the bond market.
Taper or no taper, we’ll see strong returns if we select them well.
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