8/17/2012
Dire predictions of market collapses and economic gloom in 2012 have so far proven overly pessimistic. But what should investors do to continue making money the rest of the year?
In January, many expected Europe’s debt woes to spread from Greece to the rest of the euro zone, China’s economic growth rate to falter and the U.S. to be once again gripped by a midyear market scare, if not necessarily one triggered by a debt-ceiling debate and a debt downgrade.
Given those concerns, many investors predicted the price of U.S. Treasurys, which do well when investors are fearful, would rise and the price of stocks and other risky assets would fall.
Treasury prices did indeed rise, while their yields, which move in the opposite direction, fell to record lows. But the Standard & Poor’s 500-stock index has gained nearly 14% so far this year, while high-yield “junk” bonds have returned nearly 10%. In fact, most major asset classes are in positive territory for the year.
Behind the solid performance: European policy makers have been proactive in dealing with the Continent’s problems, the decline in China’s growth rate might be coming to an end, and the U.S. economy hasn’t slipped into a recession.
Yet substantial uncertainties remain, ranging from the Federal Reserve decision on whether to launch another round of bond buying, China’s leadership transition and Europe’s wobbly single-currency zone.
To top it off, the U.S. elections in November could determine whether taxes rise or fall next year, and whether budget cuts will take a big chunk out of the gross domestic product.
“There are a lot of stresses in the global marketplace and events that could lead to volatility,” says Phil Sharkey, head of investments for the New York metropolitan region at Citi Private Bank. “You have an opportunity to look at where your portfolio is and consider whether or not you can make some changes.”
The key for investors is to find investments that still have room to rally during the next four months, but also can weather the potential downturns. Here are six ideas, culled from interviews with money managers and other experts:
High-Yield Bonds
Yes, corporate junk bonds have rallied nearly 10% this year. And, yes, their yields have dropped to 6.87%, near their lowest level in at least 15 years. Still, the asset class offers the chance to earn solid returns for the rest of the year.
Default rates are low, as the economy is doing just well enough for issuers to make their payments—and the Federal Reserve has promised to keep interest rates at rock-bottom levels. “You’re kind of in the sweet spot,” says Eric Stein, manager of the Eaton Vance Strategic Income fund, which had 29% of its $2.9 billion portfolio in high-yield investments as of June 30.
The rally, though, has made it tougher to find value. Michael Lewitt, a portfolio manager at Cumberland Advisors, which has $2.1 billion under management, says that he is looking at short-term triple-C-rated bonds—those near the low end of the rating scale—that were the result of leveraged buyouts done right before the financial crisis.
The issuers might have taken on too much debt, he says, but many still have solid businesses, limiting the chance of defaults.
Junk-bond funds that have been among the top performers this year and during the past three years include Federated High Yield Trust, Fidelity Advisor High Income Advantage and Hotchkis & Wiley High Yield Fund, according to Lipper.
Municipal Bonds
Municipal borrowers have gotten a lot of bad press this year, with cities like Stockton and San Bernardino in California filing for bankruptcy protection, sparking fears of more to come. But so far the asset class has weathered those defaults just fine, with the Barclays Municipal Bond index returning about 5% so far this year.
And since the bonds are tax-free, the returns are that much more valuable than those of other fixed-income products.
The recent bankruptcies “are very specific instances of financial trouble,” says Guy Benstead, a partner at Cedar Ridge Partners, which manages more than $600 million, speaking of the high-profile defaults. “But contagion is just not there.”
Municipal-bond yields are very attractive right now. A 30-year triple-A muni now pays 3.01%, Mr. Benstead says—1.7 percentage points more than an equivalent Treasury, once you factor in the tax break. Some states are even more generous: The average bond issued by New York state, for example, now yields 3.23%. New York is rated double-A by S&P.
“You can buy tax-free income with close to the same yield as taxable bonds,” Mr. Benstead says.
If tax rates look like they will rise in 2013, municipal bonds might get another boost. As part of President Barack Obama’s health-care overhaul, high-earning investors will be hit with a 3.8 percentage-point surtax on investment income next year. That makes munis, whose income isn’t subject to the tax, that much more attractive, says Ron Roge, chief executive of wealth manager R.W. Roge & Co. in Bohemia, N.Y., which oversees more than $200 million.
“People will realize they can shelter money in muni bonds,” he says. “Demand will go up and prices will go up.”
Investment research firm Morningstar’s top muni-bond mutual-fund picks include Fidelity Intermediate Municipal Income and Franklin Federal Tax-Free Income .
Residential Mortgage-Backed Securities
During the housing downturn of 2008, few assets were more unloved than so-called nonagency residential mortgage-backed securities—those backed by home loans that weren’t insured by Fannie Mae or Freddie Mac .
But in these days of low yields, nonagency RMBS have suddenly become popular. The reason? Once bad loans are accounted for, their yields average about 7%, more than double the yield on a 30-year Treasury bond.
They also are benefiting from the fact that no new securities are hitting the market while older bonds are slowly disappearing, as homeowners refinance the loans and pay down their balances, says Michael Murgio, chief investment strategist at GenSpring Family Offices, a wealth-management firm that oversees $15.4 billion.
At the same time, the issues that have plagued these securities are slowly being worked out, says Tad Rivelle, chief investment officer for fixed income at asset-manager TCW Group, which oversees $77 billion in U.S. fixed-income assets.
Among the positives: Mortgage servicers have been putting the infrastructure in place to deal with defaults; losses on the loans have been steady and could get smaller; and the housing market looks like it could be turning the corner.
It is difficult and expensive for small investors to buy RMBS directly. Instead, Lou Stanasolovich of Legend Financial Advisors recommends the Angel Oak Multi-Strategy Income mutual fund, which had more than 78% of its portfolio allocated to nonagency RMBS as of the end of June, according to Morningstar.
Dividend-Paying Stocks
It is tempting to look at the high valuations attached to dividend-paying stocks and say they are overpriced. But investors should remember that the last time government-bond yields were so low was in the 1950s, says Tobias Levkovich, head of U.S. equity strategy at Citigroup. He believes dividend payers could outperform as long as interest rates stay low.
That is especially true if something goes wrong in Europe or elsewhere in the world, says Jim McDonald, chief investment strategist at Chicago-based private bank Northern Trust .
He is telling clients to load up on high-quality U.S. large-cap stocks, as well as on global multinational corporations that are benefiting from U.S. stability and stronger growth in emerging markets. (For more on dividend-stock strategies, see this week’s Upside column, page B7.)
With the Bush-era tax cuts for dividends set to expire in 2013, Mr. Levkovich says investors should consider companies that are in a position to raise debt in order to issue special one-time payouts before year-end. In a recent report, Mr. Levkovich said companies like Freeport-McMoRan Copper & Gold, Marathon Oil and Best Buy could be candidates for such payouts, based on a screen that looked at debt levels and other measures.
Cyclical Stocks
Investors looking for a riskier bet should consider stocks in more economically sensitive sectors of the market known as “cyclicals,” including tech and energy, some strategists say. Such companies could see a pop if potential economic problems are resolved.
For example, cyclical stocks could benefit if U.S. economic data improve this fall after the early summer’s run of soft numbers, says Barry Knapp, chief equity strategist at Barclays . They also could rally if the U.S. elections provide clarity on taxes and budget cuts.
A lower-risk, if more complicated, bet would be buying call options, which give investors the chance to buy an asset at a predetermined price, on industrial stocks, Mr. Knapp says.
Cyclical stocks also have the benefit of being cheap. In the three months since the market’s recent low on June 12, the S&P 500 rallied 8.5%, but cyclicals underperformed “defensive” stocks by about 0.3%, according to Credit Suisse research.
That is highly unusual: During the past 30 years, it has happened just 10 times, the last time in 2006. During six of those episodes, the markets continued to rally, with cyclical stocks taking the lead.
Energy stocks now have a 12-month forward price/earnings ratio of 11.5, compared with the S&P 500’s P/E ratio of 12.8. Industrial stocks have a P/E ratio of 12.6.
Low-cost exchange-traded funds that track cyclical stocks include the Industrial Select Sector SPDR and the Energy Select Sector SPDR .
Emerging-Market Bonds
Despite the slowdown in economic growth that has hit much of the developing world, bonds issued by emerging-market nations still look attractive. Such markets used to be considered debt-laden and volatile; these days they offer cleaner balance sheets and economic growth.
They also offer something you can’t get with most developed-market government bonds: yield. The payouts might not be astronomical, but they are much better than those offered by Treasurys, Mr. Stein says, whose $6.4 billion Eaton Vance Global Macro Absolute Return fund owns the bonds of Malaysia, the Philippines and Mexico. The fund has returned 2.02% so far this year and has a yield of 3.64%.
So far this year, emerging-market bonds denominated in U.S. dollars have returned close to 12%, nearly four percentage points more than such bonds denominated in local currencies.
That might be about to change. David Rolley, co-head of the global fixed-income group at money manager Loomis Sayles, says local currency bonds offer more opportunity than those denominated in U.S. dollars, though investors should expect more volatile price swings. “Some have been very volatile,” he says. “But there’s better value in local currency bonds.”