“Preservation of Income”

Sydney M. Williams

Thought of the Day

“Preservation of Income”

July 17, 2012

Milton Friedman once famously asserted that “inflation is always and everywhere a monetary phenomenon.” While inflation has been notably low in the past few years, unsurprisingly given weak economic numbers both at home and abroad, one cannot reasonably expect that condition to continue forever. The real test for both Federal Reserve Chairman Bernanke and the Treasury Secretary will come when the Treasury will have to reduce issuance to a more normal percentage of GDP and the Fed begins to shrink its balance sheet. Thus far, betting on a return to normalcy in the Treasury market has been a mug’s game. Over the past two years, Treasury Bonds have outperformed both gold and stocks. In the past three and a half months, the Thirty-Year Treasury is up almost 10%, while stocks and gold are lower. But the rubber band has become very taut.

Last year, Treasury issuance was about 8.6% of GDP, more than double the level before the crisis. Of that issuance, the Federal Reserve purchased 61%, compared to a “negligible” amount prior to 2008, according to an article in the Wall Street Journal on March 28 of this year, in which former Treasury official Lawrence Goodman was quoted. U.S. individuals and foreign buyers have decidedly reduced their purchases to roughly 10.5% and 22% respectively.

The consequences are two fold: First, at some point, the Treasury will have to reduce issuance, as a percent of GDP, and the Fed will have to unwind their balance sheet – a euphemism for selling Treasuries. And, second, at some point there must be acknowledgement that rates on U.S. Treasuries are so low that they have been repelling rather than attracting individuals and foreign buyers, a fact confirmed by recent auctions. Current yields, in other words, do not merit the risk. (The risk being one of inflation, of course, as opposed to default.) Will the Fed be able to unwind their purchases without causing interest rates to skyrocket, and will Congress be able to reduce the deficit to ease pressure on Treasury? No one knows, but the latter seems unlikely and the former only a possibility. Also, everyone knows that our monetary base has been expanding, and they know of Mr. Friedman’s assertion about inflation.

For investors, the consequences of these actions present a Hobson’s choice: Either accept a return that is less than the rate of inflation today (and possibly significantly below what it is likely to be) or look for income and return somewhere else. Typically, when fear strikes markets, the initial response is to focus on return of capital, as opposed to return on capital. But when the only secure investment (U.S. Treasuries) pays a return less than the inflation rate, we are looking at returns of capital in a depreciating currency – not a pleasant or attractive alternative.

Perhaps it is my age, but it seems to me, in the current environment, that preservation of income is as important as preservation of capital. It used to be that capital could be preserved while still earning at least a nominal return at or above the rate of inflation. But, as stated above, that is no longer possible. Interest rates are so low on Treasuries that even a whiff of inflation will send prices falling. The Three-Month Treasury Bill provides protection against inflation, but a million dollars provides a mere $250 each quarter, barely enough to refill the liquor cabinet. Safety has become too expensive, unless one expects we are entering a period of prolonged deflation.

Since the early 1950s when the yield on stocks was regularly higher than that of corporate bonds – to compensate for owning assets perceived as riskier than their more senior cousins – stocks have generally yielded less, as they, unlike bonds, have the potential to increase their payouts.

Stock markets have sold off sharply on occasion since the 1950s, but in the early 1980s, while multiples got into the single digits, inflation kept bond yields high. In 2008-2009 many financial stocks had their dividends cut and corporate bonds got beat up as well. The current environment seems quite different. Bond funds have been the beneficiaries of money flows, and low inflation numbers have kept corporate bond yields positive. However, while rising bond prices are producing lower yields, many companies have been increasing their payouts, resulting in higher dividend yields. Regardless of the relative attractiveness, the trend toward bonds and away from stocks could persist. In fact, corporate bond mutual funds continue to see inflows – $121 billion so far in 2012 – while U.S. stock funds have seen $15 billion in withdrawals this year, $7.7 billion in June alone. When will the trend reverse? No one knows, but it will.

The concept of buying dividend-paying stocks is not new. In fact, some would suggest the field is overcrowded. Perhaps it is, but the bull market in Treasuries, which seems to be getting very long in the tooth, has propelled corporate bonds as well; so that the yield on investment grade Corporates is now 3.53% according to FINRA-Bloomberg. Their riskier cousins, according to the same data, are yielding 7.39%. Barclay’s index of corporate bonds hit 3.16% a week ago, the lowest level ever recorded. The rally in corporate bonds has been impressive over the past three and a half years; yields on both investment grade and high yield bonds are less than a third of what they were in late 2008.

Preserving capital should always be foremost in any investor’s mind, but the specter of inflation makes the choice more difficult, and makes the concept of preserving income more attractive. Along the spectrum of volatility, stocks rank high, as their price is a function of hard numbers like earnings and dividends, multiplied by people’s expectations, which are driven by emotion and behavior, a factor known as a multiple. Earnings are volatile, but tend to be less so than stock prices, and dividends are less volatile than earnings. Bonds, generally less volatile than stocks, are subject to both credit concerns and changes in interest rates. Credit concerns remain subject to analysis, but interest rates have moved in one direction – lower – over the past thirty years. Currently, Treasury rates have been kept artificially low as a function of deliberate Federal Reserve policy. When will that end? No one knows, or if they do, they are not telling. Given the potential of a surprise in inflation, the traditional means of protecting principal may not prove as reliable as they have in the recent past.

The biggest hurdle that dividends must overcome is the financial cliff we are facing on January 1, 2013, when the tax rate on dividends is scheduled to rise from 15% to 43.4% for those in the highest income tax brackets. For those in lower tax brackets, dividends will be taxed as ordinary income, plus a 3.8% surcharge to help pay for the Affordable Care Act. No matter one’s tax bracket, taxes on dividends are scheduled to rise significantly, barring some action in Congress. Nothing is certain in the uncertain world of investing, but it wouldn’t be surprising if some companies declared special dividends at the end of this year, before tax rates go up.

Trying to predict Congressional action is another mug’s game. Nevertheless, preserving income looks to be a sensible strategy at a time of extraordinary low Treasury yields.