With interest rates at record lows, income-seeking investors who were used to relatively safe bond investments with decent yields have to look elsewhere.
Either that or settle for “virtually nothing to keep their powder dry and earn a bit more than what money-market funds pay,” said Dan Genter, CEO of RNC Genter Capital Management in Los Angeles.
This means bond investors need to fall in love with dividend stocks. You can review some of Genter’s picks at the bottom of this column.
‘Investor’s hell’
Money-market funds have been waiving their expenses to keep their yields from falling below zero. The Federal Reserve lowered its target for the federal funds rate to a range of zero to 0.25% in March. So now the yield curve for U.S. Treasury securities is narrow, with three-month Treasury bills
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yielding 0.11% and 10-year Treasury notes
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yielding only 0.71%.
The distorted bond market has been described as a “borrower’s paradise and a fixed-income investor’s hell” by Mark Grant, the chief global strategist for fixed income at B. Riley FBR, even as he agrees that the Federal Reserve had no choice but to lower the federal funds rate and push bond yields lower by purchasing securities to help spur an economic recovery.
In an interview, Genter described the fixed-income market this year: “It is as much of a challenge as I have seen in 41 years.”
RNC Genter Capital Management oversees about $5 billion, mainly for institutional clients, about evenly split between fixed-income (mostly municipal bonds) and equities.
A bond investor will face the continuing problem of redemptions, which means investments with higher yields get pulled out from under them, requiring new vehicles for generating income. If you stick with bonds, “you have to go down the risk curve on the corporate and municipal side, which in this environment is even more complicated,” Genter said.
The risk for corporate bonds is obvious: Default and bankruptcy because of sharp decreases in revenue (sales or rental income) and cash flow, during the COVID-19 clampdown. For municipalities, the risk is from declines in tax revenue. Bond-rating firms “are giving municipalities a longer runway before they downgrade,” Genter said. “We are going to see significant downgrades in the investment-grade-rated municipal space,” he said, in part because municipalities are seeking to lock-in low interest rates by issuing more bonds.
Genter pointed to elevated risk for municipal bonds backed by revenue-generating projects, including sports stadiums, concert halls and auditoriums.
“They are breaking contracts,” he said (referring to teams or other entities that would normally use those venues), which means the municipal issuers may not be able to make interest payments. So investors had better learn quite a bit about a municipal bond deal, the health of the issuer and the nature of the revenue backing the interest payments, before taking the plunge.
For corporate bonds, the ratings firms “will jump” to downgrade bonds if a company has “significant debt service to cash,” Genter said.
A downgrade doesn’t necessarily mean investors will suffer. Then again, with low interest rates pushing bond prices so high, investment-grade yields aren’t attractive. The S&P Municipal Bond Index has a “yield to worst” of only 1.34%, according to FactSet. Yield to worst is the yield to the earliest retirement date for a bond. For corporate bonds, the Bloomberg Barclays Aggregate Bond Index has a yield to worst of 1.16%, according to FactSet.
Dividend stocks
Genter called dividend stocks “one of the few games in town” for income-oriented investors.
His team manages the RNC Genter Dividend Income, which is small, with only $20 million in assets, but has a four-star rating (out of five) from Morningstar.
Genter said that he and his team select from all stocks listed on U.S. exchanges, with an emphasis on a good history of paying and growing dividends, with no cuts for at least five years. New positions must have dividend yields of at least 2.5%, well supported by free cash flow.
A company’s free cash flow is its remaining cash flow after planned capital expenditures, including interest on debt. The remaining free cash flow can be used for dividends, buybacks or other corporate purposes.
So Genter and his team focus on companies’ cash flow generation and debt service when analyzing stocks. Their emphasis is on companies they believe…
Read More: Don’t settle for skimpy bond yields and make dividend stocks your best income