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Jubak's Journal
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How to shop the interest-rate fire sale
This weeks Fed increase marked the end of an era, and some income investors may panic and sell everything with a yield. Here are 3 great bargain-hunting grounds.
By Jim Jubak
The Federal Reserves June 30 announcement that it was going to raise interest rates 25 basis points may have been short on drama, but it still signaled the end of an investing age.
Starting in 2001, 13 interest-rate cuts took short-term yields from 6% to 1%, where they stayed from June 2003 to June 2004. Investors have now entered a period of uncertain duration where interest rates will be headed higher, if theyre headed anywhere at all.
The financial markets are just now in the initial stages of adjusting to that shift, a stage that is dominated by shock, dismay and overreaction. Investors are being offered advice that basically amounts to Sell everything with a yield and sort it out later because everyone knows future rate increases will send the prices of todays bonds, investment trusts and yield stocks tumbling.
But I think its a good idea to do some of that sorting out now rather than later. The truth is that the adjustment to higher interest rates, even if it temporarily takes the price of just about every asset trading on its yield lower, doesnt reduce the value of each one of those assets. In the longer run, some prices will go back up to adjust to values. Professional investors know that if they can identify such short-term mispricing, they can collect solid capital gains to go along with their interest payments. I dont see any reason that individual investors should miss out on all the fun and profit.
Let me identify three promising areas where investors can go hunting.
Real Estate Investment Trusts (REITS)
You dont have to look very hard to see the relationship between higher interest rates and lower REIT prices. The Morgan Stanley REIT Index ($RMS.X, news, msgs) peaked on April 1 and then went into a slide on fears of higher interest rates that chopped 19% off the index by May 10. However, when the yield on the 10-year Treasury note actually fell and then stabilized in the weeks leading up to June 28, the index and REIT prices rallied to climb 14%. As the Feds June 30 meeting approached, however, the index dipped again, falling 1% on June 29 and 30.
That kind of extreme sensitivity to interest rates makes sense for most of the REIT sector. Investors buy REITs because they yield more than Treasury notes, so anything that raises the yield on Treasurys creates more competition and price pressure on REITs. Thats especially true when REITs trade at a premium to their net asset value (NAV), the value of the real estate that the REIT owns. Historically, REITs have traded at a 2% premium to NAV, according to Merrill Lynch, but that premium had climbed to 19% at the beginning of 2004 as investors were willing to pay higher prices for REITs in their quest for higher yields.
A couple parts of the REIT sector may actually do better if interest rates tick up modestly because the economy is growing strongly. Office REITs, for example, should see higher cash flow as the economy increases the demand for office space. Professional investors have already recognized this, bidding up the prices of office REITs to high premiums over NAV.
The same logic applies to apartment REITs where premiums to NAV are much more modest and which stand to get an extra boost as higher interest rates turn some homebuyers into home renters. The apartment sector is in the early stages of quite a turnaround. The first quarter of 2004 saw rising effective rents for the first time since 2001. Current trends show new demand outpacing new supply by the end of 2004, which should drive occupancy rates to 95% by the end of 2005 from 93% in the first quarter of 2004, according to projections by Bear, Stearns & Co. Effective rents will climb 4.5% in 2005, Bear, Stearns calculates.
A couple of top-quality apartment REITs now trade at relatively modest premiums to NAV and, if the sector pulls back again, investors could see a return to the discounts to NAV that these stocks showed in May. Equity Residential (EQR, news, msgs) traded at $29.73 at the close on June 30, a 14% premium to the $26.19 that Merrill Lynch calculates for the REITs NAV. But Equity Residential traded at $27.29 on May 19, just a 4% premium, and the price could easily retreat to that level again. The yield is 5.9%. Another apartment REIT to watch is Archstone-Smith Trust (ASN, news, msgs). The REIT closed at $29.33 on June 30, an 8% premium to Merrill Lynchs estimated NAV of $27.24. The REIT traded at $27.23, a penny below NAV, on May 19. The yield is 6%.
Municipal bonds: showing up history
Yeah, I know munis are bonds and bond prices go down as current interest rates rise. But some bonds go down more than others, and changes in supply play a big role in setting bond prices. Right now, municipal bonds are paying a very high relative yield: Historically, the tax-exempt yields on municipals are about 80% of the yield on 10-year Treasury notes. That ratio climbed all the way to 95% in 2003 as the huge supply of new municipal bonds forced state and local governments to pay higher yields. At the current ratio of just about 90%, investors are still getting a bigger-than-historical bang for their municipal bonds buck.
But this relative advantage may not be all that muni investors can look forward to. The supply of new munis has been shrinking. In the first quarter, it was down 33% from the same period in 2003, according to Pacific Investment Management (better known as Pimco). And it looks set to fall further in the rest of 2004 as higher interest rates cut into the number of local and state governments that pay off old bonds with new issues, and as governments who have rushed to beat the rate increase hold off on any bond sales for a while. Add that supply contraction to the higher-than-historical yield of municipal bonds relative to Treasurys, and youve got a recipe for limited gains in municipal bond prices.
Intermediate corporate bonds
I got a real shock the last time I opened my Dads portfolio to track the price of his General Motors (GM, news, msgs) bonds. I was worried that Id already missed the window for selling them and that he was looking at a loss of capital. So it came as a very pleasant surprise to see that the bonds had actually gone up in price, a bit, while interest rates were climbing.
Chalk this one up to the way time works to turn intermediate bonds into short-term bonds. When we bought them in July 2002, these five-year bonds paid 5.6%, a tidy return when the yield on the five-year Treasury was just 3.9%. Of course, interest rates have ticked up since then and the five-year Treasury now yields 4%. Naturally, you might expect my Dads bonds to have dropped in price, but these arent five-year bonds anymore. They mature in 2007, now only three years off. The three-year Treasury currently yields just about 3.3%, so that 5.6% yield actually looks even better than it did in 2002.
As long as the pages of the calendar tick over more quickly than short-term interest rates rise, then bonds like this should hold their value and maybe even appreciate a bit. For example, in another year, my Dad will be holding a two-year bond with a coupon yield of 5.6%. The current yield on the two-year Treasury is 2.8%.
The winner in a race like this depends on the shape of the yield curve. As long as inflation fears remain relatively low, yields on new two-, three- and five-year Treasurys should climb slowly enough so that a bond like this one will hold or appreciate in value even if short-term rates increase. Its only if short-term rates go up and investors come to believe that the Fed has lost the fight on inflation that intermediate yields race ahead. If that happens, a bond like this will get hit hard by climbing interest rates. Id use intermediate corporate bonds with three-to-five-year maturities in a strategy like this.
These are just a sampling of the kinds of strategies Id be thinking about as an income investor. There are others -- looking at closed-end funds trading at discounts to NAV comes to mind (but watch out for that demon leverage) -- as Im sure youll let me know in your e-mails.
Happy hunting.
New developments on past columns
Second-quarter 2004 performance for Jubak's Picks
Its time for the end of quarter (and longer) performance numbers on Jubaks Picks. It was a very, very tough quarter. In any period I try to take what the market gives, and just about the only thing it gave investors this quarter was volatility. To take advantage of those rises, falls, and rises again in prices, I traded more than I normally do. So for example, I re-bought shares of Inco (N, news, msgs), which I had sold on Dec. 23, 2003, on May 7, and then re-sold them on June 29. I dont see the next quarter turning out very different, Im sorry to say. Heres how I did against the major indexes:
| Jubaks picks vs. the major averages | | Index | Second quarter 2004 | Trailing 12 months | | Jubak's picks | 4% | 33% | | Nasdaq Composite | 3% | 22% | | Standard & Poor's 500 | 1% | 15% | | Dow Jones Industrial Average | 1% | 14% |
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Pretty good numbers in a tough year: Im up 11% for 2004 to date. Here are the three-year numbers, which reflect the beating administered by the bear market of 2000 through 2002, and the numbers since the inception of the portfolio:
| Jubak vs. the indexes -- the long-run picture | | Index | 3-year return* | From inception** | | Jubak's picks | +18% | +114% | | Nasdaq Composite | -5% | +51% | | Standard & Poor's 500 | -7% | +40% | | Dow Jones Industrial Average | -6% | +47% |
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*Close on June 29, 2001, through close on June 30, 2004. **May 7, 1997, through June 30, 2004.
As is my practice, I will update these performance numbers at the end of the next quarter in September.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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