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| Jubak's Journal | 5 energy stocks for income investors
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With bonds looking dismal, income investors need alternatives. Here are 5 picks for a new income-stock portfolio I'm launching.
By Jim Jubak
The U.S. Federal Reserve has made life a lot more difficult for income investors. Not only are yields low, as they have been for quite a while, but now income investors face a greater risk of losing capital. So what are you going to do about it?
Me? I'm launching a new portfolio, just for income investors, to help you navigate what has become an even more treacherous stock market. The goal -- and it's not as modest as it sounds -- is to find equity investments with yields above the 4.5% paid by the 10-year Treasury note currently and that are safer than the 10-year Treasury under current market conditions. In today's Part I, I'll pick the first five stocks for the portfolio.
For the last 15 months, ever since the Federal Reserve started to raise short-term rates, income investors have dodged a bullet. Alan Greenspan and Co. have raised short-term interest rates to 3.75% this September from 1% in June 2004, but long-term interest rates have refused to follow suit. Normally when the Federal Reserve starts to raise short-term interest rates in order to lessen the danger of future inflation, long-term rates start to edge up. But it didn't happen this time: The yield on the 10-year Treasury stood at 4.69% at the end of June 2004. After 11 short-term rate increases, it had fallen to 4.3% on Sept. 30.
Investors who had decided to risk their capital to get the higher yield on the 10-year Treasury had won their bet. Bond prices go down when interest rates go up. So if long-term yields had followed their normal pattern and climbed as the Fed raised short-term rates, investors who had bought 10-year Treasurys would have seen the value of their bonds fall. If the yield on 10-year notes had climbed to just 5.25% in a year from 4.69%, investors would have seen the market price of $1,000 in Treasury notes fall to $893.33. That 10.7% loss of capital would have more than wiped out the 4.69% in interest income paid by the note.
Confidence, reconsidered
Lots of experts have weighed in with explanations for why bonds didn't behave as they normally do -- why long interest rates fell while short interest rates rose. But here's the reason that's most important for investors over the next 18 months. Long-term interest rates didn't go up, this argument goes, because the bond market was convinced that the Fed is so smart and so powerful that it simply won't allow any increase in future inflation.
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I don't discount explanation No. 1, and that's what worries me and should worry all income investors. If long-term rates moved lower because the bond market thought the Fed had inflation under control, long-term rates will move higher if the bond market feels the Fed has lost control. And there's evidence that the bond market is at the least rethinking its belief that the Fed has everything under control.
Take a look at the bond market's reaction to a series of warnings from the Fed in the first week of October. The warnings culminated in the now infamous "virus" speech of Dallas Federal Reserve President Richard Fisher. The Fed can't "let the inflation virus infect the blood supply and poison the system," Fisher said.
Instead of being reassured by these remarks that the Federal Reserve was on the job and ready to do whatever it takes to stop inflation dead, the bond market proceeded to send yields on the 10-year Treasury steadily higher. The yield on the 10-year Treasury note closed at 4.45% on Oct. 12, up from 4.23% on Sept. 23. That has produced a 5.1% loss for bond investors.
My opinion is that after telling the capital markets for so long that everything was under control and creating the expectation that one or two more interest rate increases would do the job, the Federal Reserve has now succeeded in spooking the bond market by going public with these worries.
Two options, one solution
Knowing that Alan Greenspan's term as Fed chairman ends Jan. 31 only reinforces the bond market's doubts. Greenspan has said that he won't stay on after his term expires, which leaves the bond market contemplating life without the man it has come to rely upon since he took over as chairman in August of 1987.
I think income investors have two options here. First, you can hang in with whatever strategy and portfolio you currently have and hope that the bond market will dodge another bullet. Maybe long-term yields will pull back from their recent run up on fears of a recession, or the theory of a global savings glut will turn out to be true, or pension funds really are buying enough long-term Treasurys to keep yields low. Maybe the bond market will stop worrying about the Federal Reserve's ability to control inflation. And maybe President Bush will pull a great, confidence-building replacement for Greenspan out of his hat.
Could happen. But the odds that long-term yields won't be higher a year from now are worse than they were last year. And the odds that bond prices will be lower -- leaving bond investors with some dings to capital -- are greater than they were a year ago.
I prefer a second alternative: carefully laddering as much of my long-term bond portfolio as possible so that I can hold my long bonds to maturity, if I have to, rather than selling them at market prices (which might be lower), and moving some of my income assets out of bonds and into income stocks.
I think that's an especially attractive alternative right now. First, the sector of the economy that has brought investors heightened inflation worries -- the energy sector -- will be swimming in cash flow that can go to higher dividends if those inflation fears are correct. And second, energy stocks are currently selling for modestly lower prices in the stock market thanks to October's profit-taking.
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