Bonds, dividend stocks, and bond funds have been emaciated on one very specific fear: the Federal Reserve will taper its bond-buying program too early, causing bond yields to jump to normal, pre-crisis levels, and effectively kill the profit margins of some funds while lowering the incentive for investment in other asset classes, like dividend-yielding stocks.
Yesterday, we saw bond funds, dividend stocks, and mREITs outperform the market after news spread that Bernanke was not, in fact, going to pull the plug on the bond buying program that has largely contributed to low rates, cheap leverage, and growing focus on income-yielding assets outside of the U.S. treasury market
Here’s a closer look at how the news has caused upside price growth in three asset classes, and why each of them is doing well for different but related reasons.
Beat-up BDCs
Business-development corporations are a specific group of high-yielding, well-diversified, but high-risk companies that lend at high rates to a large number of small and usually private companies. BDCs are often a good way to get exposure to private businesses and small town America, since these companies invest in main street more than Wall Street.
That being said, the companies have seen a huge flight of capital even at a time when many investors expect America’s economy to improve. This paradox again points back to bonds: as bond yields go up, the borrowing costs for these companies go up. This, in turn, will hit their profit margins. Or so the theory goes. Contrarian investors have pointed out that, yes, borrowing costs are fated to rise, but that means BDCs can charge higher interest rates to small businesses, which in turn will yield higher profits.
The end result: BDCs are, as a group, low. At the end of June the UBS AG BDC ETF (BDCS) was down over 5% from a month prior. Absurd acronyms aside, that’s a horrifying depreciation in a market that trends towards stability thanks to diversified holdings.
Stability began to return at the beginning of this month as BDCs hit a bottom. Yesterday, the ETF rose 1% in intraday trading and is flat from its point in May, and is even up a little form the beginning of year. Excluding dividends, which are considerable in this sector.
Empty Returns in mREITs
Then there are the mortgage REITS (mREITs), which take advantage of the spread between long-term and short-term Treasury rates by borrowing at the short-term rates and lending at rates tied to the higher term. These have been hit to a degree largely unseen since the 2008–agency mortgage focused American Capital Agency Corp (AGNC) and mREIT veteran Annaly Capital (NLY) are down over 20% in the past two months.
Many mREITs are selling at discounts to book value–meaning your share of the fair market value of the company’s total assets exceeds the price you pay for them if you buy today–which is encouraging a number of distressed equity experts to take a close look at these companies. But retail investors looking for high yields have been badly burned; dividend cuts and fear of higher rates have made retirees flee these names in huge numbers.
Yesterday, a partial reversal of that trend was observed as AGNC rose around 5% in intraday trading and NLY rose around 3.5%. While they’re by no means back to levels seen just a couple short months ago, a lot of investors are coming back to these names on the hope that tapering will come later rather than sooner.
Battered Bond Funds
With the expectation that Treasury yields will rise more than they already have, the market has priced in the concomitant fall in bond fund values. The assumption has been extremely negative: these funds lack the management acumen and capital to adjust to the rising yield rates and take advantage of newly issued and higher yielding bonds. Those who disagree with this assumption has seen value and made a floor for prices.
But the floor is not very high. One of PIMCO’s leveraged bond funds (PMX) fell to multi-year lows and offered a yield exceeding 8% at its lowest point. It’s since recovered slightly, but is still in the doldrums. iShares long-term treasury ETF (TLT) is still down 15%, with a half percentage point recovery on the anti-tapering news from the Fed.