Sometimes, someone says it better than you can...so the best thing is to quote that person.
I am often asked the question: why do you invest in bonds/preferreds (and select high-yielding stocks) in an environment of rising interest rates?
Well, excepting the fact that the 10-year Treasury yield is now 17 basis points lower than it was in early July, I do comprehend the possibility of rising rates and thus can't dodge the question.
But I can get someone else to answer it for me, in this case legendary bond investor Bill Gross. Gross' most recent monthly investor letter has drawn much attention for his bold proclamation that he, and his firm PIMCO would win the "bond wars."
While conceding that bond investors may have to accept lower returns (mainly because there is very little room for rates to decline on an absolute basis), Gross correctly points out the key tactical maneuver necessary for bond investors to beat benchmarks: embrace the carry.
As Gross points out carry is another term for yield, but as he also points out, it is more specifically a measure of risk undertaken by the investor. He mentioned four other types of carry -- maturity, curve, currency, volatility -- but my firm's (and my column's) focus is on credit, specifically finding instances where the market is overstating credit risk for a specific company.
Gross didn't really touch on the main competition to bonds, of course stocks. This chart from www.multpl.com shows why I am not bullish on stocks (and Gross doesn't seem to be either). The REAL return on stocks, i.e., the dividend yield, has fallen below the 2% benchmark, and thus, after a brief inversion, represents a significant discount to the yield offered by the 10-year Treasury note. That combined with a run-up in "P" that has been combined with, at the margin, a decline in "E" (earnings expectations for the S&P 500) and that's why I'm not bullish on stocks.
But never forget that "carry equals risk" and I wholeheartedly agree with Gross that more risk must be taken to achieve superior returns in this environment. At Portfolio Guru, we take that risk by identifying undervalued corporate fixed income securities, and, in most cases, buying them at a discount to par.
Thus, we are getting superior yields (we are currently buying securities that are yielding 9% to 13%) AND the possibility of capital gain as misunderstood fundamentals are re-priced -- and the discount to par shrinks.
I've mentioned our favorite preferred shares in this column -- Gastar Exploration (GST), Magnum Hunter (MHR), Miller Energy (MILL), GreenHunter Resources (GRH), Armour Residential (ARR), Evolution Petroleum (EPM) -- and we own them all for our clients.
Some of these companies are small enough (and their fixed income securities illiquid enough) that Gross and PIMCO could never dream of buying them. But Portfolio Guru is not PIMCO, and, sadly, you are not Bill Gross. However, you (and my firm) CAN buy individual-company securities and generate above-market returns.
Your house probably isn't as nice as Gross's in Newport Beach, Calif., (mine isn't), but if you aspire to that lifestyle, you should follow his advice and embrace the carry. And if you identify mispriced fixed-income securities, you may even find you can better his returns... if not his square footage.
At the time of publication Collins' firm owned GST-A, MHR-C, MHR-D, MILL-C, GRH-C, ARR-A, EPM-A.