FMD Capital Management

High Yield Hits and Misses

Written by David Fabian, November 26th, 2013

One of the themes for 2013 has been the rotation in high yield asset classes that has seen money change direction based on the prevailing sentiment in interest rates.  Income investors have also been forced to contend with the “new normal” of anticipating the Federal Reserve’s policy changes in order to stay ahead of the interest rate curve.   This has led to a variety of hits and misses in high yield securities such as junk bonds, master limited partnerships, mREIT’s, and preferred stocks.

The following analysis highlights the areas of strength and weakness this year as well as their outlook moving forward. 

Hit: Junk Bonds and MLPs

One of the sweet spots in the high yield arena have been junk bonds as income investors have been eager to swap interest rate risk for credit risk.  The fear of higher rates has pushed money out of traditional safe havens such as Treasuries and municipal bonds for more credit sensitive fixed-income securities.

As I highlighted several months ago, the best risk to reward in this space has been in short duration ETFs such as the PIMCO 0-5 Year High Yield Bond ETF (HYS) or the SPDR Barclays High Yield Short Term Bond ETF (SJNK).  According to Index Universe, these ETFs have combined to accumulate $4.7 billion in new assets this year and are currently sitting near all-time highs.

Many market watchers have been wary about the continued strength of high yield bonds considering how tight spreads have narrowed compared to Treasuries.  With the threat of taper looming, at least one credit analyst from RBS believes that high yield bonds are still a good value when compared to high-grade corporate debt.  My personal opinion is that as long as the Fed remains accommodative and the market continues its upward march, we will likely see continued prosperity for high yield debt.  However, a pullback in stocks will likely lead to at least a modest dip in this sector.

Another area of strength has been master limited partnerships, of which the Alerian MLP ETF (AMLP) is still the biggest of the group with over $7 billion in total assets.  The commodity sector has had a volatile year; however the income stream that MLPs derive from their infrastructure leasing and development has been rock solid.  AMLP has gained nearly 18% this year and is currently paying a yield of over 6%.

One of the advantages of owning an ETF instead of an individual MLP is that you don’t have to deal with the tax headache of a K-1 on your tax return and you get the benefit of diversification amongst a similar segment of companies.  If the economy stays on track, I expect that MLPs will continue to perform well in 2014.  However, they are susceptible to periods of volatility which is why it makes sense to have a sell discipline in place to define your downside risk.

Miss:  mREITs

One of the themes that is most susceptible to the threat of rising interest rates are mortgage REITs which derive their income from borrowing money cheaply and purchasing higher yielding mortgage paper through leverage.  This “carry trade” has been one of the biggest benefactors of the quantitative easing efforts from the Federal Reserve over the last several years.  Investors chasing double digit yield were lured into this sector, only to watch the bottom fall out this year.

The iShares Mortgage Real Estate Capped ETF (REM) invests in a basket of mREITs and has a current 30-day SEC yield of 12.68%.  However, when interest rates started rising sharply in May, REM quickly found itself in trouble and is currently more than 20% from its high.

There is still likely a great deal of volatility to come in REM as we make our way through the remainder of the year and into 2014.  That may resolve itself into swift moves to the upside or downside.  With so much uncertainty about the future of Fed tapering, it’s hard to know how mREITs are going to react moving forward.  My advice is to avoid the sector unless you have a high tolerance for risk or want to average into a position slowly over time.

On the Fence: Preferred Stocks

Preferred stocks have been subjected to bouts of volatility this year as well but are still sitting close to the flat line for the year.  The iShares US Preferred Stock ETF (PFF) currently has $9 billion in total assets and a yield of nearly 6%.  This sector is typically dominated by preferred holdings in financial companies, real estate, and banks.

I think that PFF represents a more attractive value proposition when compared to traditional dividend paying stocks that are on their highs.  I currently own a position in PFF for myself and my income clients as a hybrid instrument with both equity and debt characteristics.  The monthly income stream is a luring quality and continued strength in the financial sector will likely bode well for this ETF moving forward.

The Bottom Line

As we head into 2014, be sure to keep an eye on the trends of these four sectors as we will likely see continued rotation and trend changes.  Hot areas of high yield may falter and new sectors may eventually take their place.  Remember that even with the threat of rising interest rates; there will still be opportunities for growth and income.  The key is identifying these trends and capitalizing on them when the timing is right.

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