Investments and low interest rates; an analysis

In the latest issue of the Wall Street Journal, an article ran that described investors growing increasingly frustrated with low bond yields and abandoning those assets for seemingly more profitable alternatives. As the markets prepare to turn the corner into 2012, one thing is clear to all; times are tough and saying that the state of global economy leaves better to be desired is an understatement as drastic as all else. It is also painfully evident that bond holders will likely remain dissatisfied with their overall returns for the next few years.

The point the article made was that one can find solutions to any kind of problems, and remedies exist even for this seemingly insurmountable toil. They require of course a level hand and some patience, but making an investment into municipal bonds that are exempt from taxes can provide a nice alternative. As does perhaps an investment into foreign nations that possess stronger balance sheets than the U.S. Or perhaps a well-balanced portfolio consisting of blue-chip, high dividend stocks? The following is a deeper view into the alternatives one can look into when learning how to invest in a low-interest rate niche, and the pitfalls one may encounter on the way.

TAX-FREE MUNICIPAL BONDS

One kind of assets that is almost always unerringly bountiful are tax-exempt municipal bonds. These investments manage to garner higher yields than Treasuries at nearly all maturity levels. And that, even without accounting for the advantages that tax exemption offers to investors. Of course, such a pattern is not a normal one and one cannot reap the benefits of the absence of taxes to no end, since the sooner or later, markets begin to demand certain premiums to be shelled out for tax-exempt municipal bonds. Trends always give way to history. Furthermore, tax-free municipals cannot be the deftest choice for accounts that are tax-deferred, simply because the yields CD’s garner are much higher than those of tax-exempt municipals.

The general rule of thumb prevailing over the market right now is that the primary reason why higher yields are so prevalent at the moment is because the municipal market also carries higher credit risk. However, that assessment may not be as accurate as one may think. Three other alternative lines of reason can be applied to this:

-          Municipal bonds are less liquid than Treasuries; therefore, they possess a premium on liquidity.

-          In order to make an investment in a healthy, well-established environment, one always naturally looks towards Treasuries.

-          There are currently healthy doses of uncertainty and scepticism circling tax-exempt municipal bonds at the moment, as President Obama has already called for federal taxes to be applied to some traders.

INTERNATIONAL BONDS

Presently, there are two major reasons why non-greenback bonds are not deemed a good substitute for high quality dollar fixed securities. One of these reasons, and by far the main one is of course that the involvement of a currency risk in an investment adds to overall risk the investor takes. Once all of the fluctuations and uncertainties of the currency index find their way into your portfolio, the volatility of the investment itself goes through the roof as well. it certainly detracts from the simplicity of the process. The other reason is that trading in foreign currencies directly ties an investor to the equity markets, which always run parallel to stocks, meaning that the investment will do just as poorly as the stock market does.

A perfect example of such a phenomenon would be a look at Australia, a nation that has a debt-GDP ratio of roughly 25%. The country also has a young thriving population and a plentiful supply of valuable natural resources. The S&P 500 Index sank 14 points in the third quarter of the year 2011. Yet those buying into Australian bonds and leaving the currency risk without hedging only went down 10%, since that was the approximate amount that the Australian dollar fell against the greenback. This in essence is the point of the practice. Once a strong flight to quality occurs, the U.S. dollar almost always gains strength against other currencies. As a result of that, foreign bonds begin generating negative outcomes.

DIVIDEND STOCKS

This third option can seem a flawed logic at the core. Exchanging high quality bonds for stocks that pay out high dividends make one question the initial purpose of having bonds itself. One of the most crucial aims of making an investment into bonds is of course to have apt shelter if and when the market tumbles. Yet that factor is far from being a perennially certain one, and can leave an investor unprotected during the worst of times.

In the spring of 2009, the market crash was entering its last stages. The six months before saw 46 firms in total slashing their dividends. The number is a staggering one, when compared to the total of 17 companies who did so throughout the entirety of 2007. The blue chip stocks, which the articles strongly recommended also fell prey to these cuts.

General Electric made an official announcement that it were to cut 68% as part of its very first dividend cut in February of 2009. During the previous month, Pfizer announced a 50% cut of its dividends. Finally, Newell Rubbermaid made two severe dividend cuts in the alarmingly short span of three months, the second one being at the end of March of 2009.

In addition, high dividend stocks are prone to the same inherent risks as regular stocks, as during times of market stress stand the same chance of depreciating in value. High dividend bonds however are exempt from that particular danger. That is why, the attention of investors should perhaps lie with the total returns, which are or course the dividends plus all of the capital appreciation/depreciation. Mere dividends will give your investments peace of mind.

Total returns should also be a main source of focus for investor due to the fact that paying copious amount of attention to high-dividend stocks may cause one’s portfolio to lack diversity, since a considerable number of firms do no pay dividends.

The article’s most feasible and sound suggestion is an investment in tax-free municipal bonds. One should make sure they are of high quality, suggesting a rating of AAA or AA. However, a rating of A could also prove sufficient, if the bonds have less than three years in maturity. Ensuring that bonds belong to strong sectors is also key, with general obligations or essential revenue leading the way.

If that does not bring you close to your ultimate financial goals, then you might consider simply increasing your allocation into a diverse stock portfolio instead of ceding to the latter advice of the article. As interesting as it may sound, foreign bonds and high dividend stocks simply carry too much inherent risks and uncertainties in order to make for a well thought out alternative to traditional trading.

By Chris Termeer