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Bond Buyers: Be Wary

By Roger Conrad on March 12, 2010

A year ago, in March 2009, investor sentiment could hardly have been worse. And with good reason: The stock market had suffered one of its worst 12 month-periods in memory, credit was tight, the economy was in full retreat, and Washington was pushing an activist agenda. The strong feeling was that things would get much worse before they got better.

As it turned out, the gloom proved to be an historic buying signal for stocks, just as extreme pessimism has been so many times in market history. The S&P 500’s 56 percent return over the past 12 months hasn’t come close to erasing the 44 percent loss in the 12 months that came before. But it is one of the more impressive runs in decades.

In fact, coupled with the still-weak state of the US economy, the speed and magnitude of the gains have convinced many that the run is done and that it’s time to abandon stocks.

To be sure, bets on the broad stock market have been a loser’s game for some years now. Over the past 10, for example, the index is down 26 percent, 12 percent including dividends. The blue chips have had their moments. But even after the explosive rally of the past year, the S&P 500 is still off 25.5 percent (including dividends) for the past two years.

My bet is the big cap average will also be a laggard for some years more. This year, for example, it’s vulnerable to both a potential worsening of economic conditions and a possible revival of inflation. American banks aren’t nearly as vulnerable to disaster as they were a year ago but are still hardly a picture of health. Meanwhile, the Obama administration is still pushing major new regulation onto industries across the board, and the specter of higher taxes looms with Bush cuts slated to expire in 2011.

Unfortunately, many income investors are abandoning stocks for what could prove to be an even bigger bubble in bonds. Worse, they’re doing it for potential returns that rate among the most meager in history.

If the stock market was on the ropes in March 2009, so was the bond market. The benchmark 10-year Treasury yield was at one of its lowest rates ever, bouncing along well under 3 percent–the result of a massive rush to safety in late 2008 that took it to a low of barely 2 percent on December 18.

Yields for even A-rated corporate bonds, however, were running at 8 percent and higher. The market for anything junk, meanwhile, was virtually non-existent. And woe to any company that was forced to issue bonds, whether it was to refinance existing debt or to finance a transaction, as borrowing rates surged as high as the mid-teens for more aggressive deals.

The reversal in the bond market since then is one of the most impressive in history. The 10-year Treasury yield, normally a benchmark for all interest rates, has risen sharply off those late 2008 lows and today stands at roughly 3.77 percent. Everything else, however, has gone in exactly the opposite direction.

A-rated Southern Company (NYSE: SO), for example, paid a yield-to-maturity (YTM) of more than 8 percent on its 10-year debt at the peak of the crisis. YTM takes into account a bond’s move back to par value ($1,000) when it matures and therefore is the best measure of current borrowing rates.

Today, that same Southern bond has a YTM of just 4.092 percent, barely half the year-ago level. The key is risk premium. A year ago, worried investors required a yield of 5 to 6 percentage points more than Treasuries to buy Southern Company bonds. Today, they’re requiring just 32.2 basis points or 0.32 percentage points more–in other words virtually nothing.

The same massive contraction in risk spread has extended even to bonds rated much lower than Southern’s. Enterprise Products Partners LP (NYSE: EPD), for example, is arguably the very safest of all master limited partnerships (MLP), but it nonetheless draws a rating of just BBB-. A year ago, the MLP’s bonds were paying a YTM of nearly 10 percent. Today, the closest issue Enterprise has to 10-year debt (a maturity date of Jan. 31, 2020) has a YTM of just 5.13 percent. That’s a premium of just 136 basis points to 10-year T-notes.

Finally, take Sprint Nextel (NYSE: S), a company that’s been losing its wireless customers to the iPhone and various Blackberry devices at a frightening pace and is rated just BB- by Standard & Poor’s with a negative outlook. Even that company has five-year paper with a YTM less than 500 basis points above Treasuries.

Winners and Losers

First the positives–and they are considerable.

Such low corporate borrowing rates haven’t yet translated into job growth in the US. But they have given Corporate America–great and small–a once-in-a-generation opportunity to recapitalize balance sheets to their strongest in decades.

For some companies, low rates have fueled major refinancings on a scale and at a lower cost than management could have imagined a year ago. Rather than face a pending credit crunch, they’ve been able to restructure their balance sheets to fund growth and slash interest expense.

For stronger companies like Southern, the new rates are boosting near-term earnings as well as putting the pieces in place to fund massive planned capital spending in coming years. Others have financed acquisitions of choice properties from distressed owners, a formula for powerful profit growth particularly as the economy returns to health.

Stronger balance sheets and growth funded at low rates is a sure-fire formula for safe, robust and reliable dividend growth–which, in turn, is the primary fuel for pushing dividend-paying companies’ share prices higher over the long pull.

The upshot: The refinancing boom is an extreme positive for stocks, particularly dividend-paying stocks. And with investors focused on the possibility of a stock market correction, it’s a major positive that’s by no means reflected in today’s share prices. That’s very bullish for the rest of 2010 and beyond, even if the S&P 500 has another relapse.

Now the big negative: Rarely has there been a worse time to buy bonds. The converse of companies being able to sell their bonds cheaply is that investor yields are paltry.

Big institutions running billions of dollars may be willing to buy 10-year Southern bonds with a yield to maturity of barely 4 percent, or to snap up some Sprint bonds with a higher YTM but a lot more risk. So might foreign investors looking for a temporary bet on the US dollar, which is still performing as a safe haven when the economic news seems to turn sour.

That’s because they move money around for a living, and a few basis points upside on a purchase is enough to meet their goals. They’re hardly thinking of locking down money for 10 years. But they’re perfectly willing to bid Southern bonds to a YTM even less than the 10-year Treasury if they can get a few more basis points of profit out of the deal.

We individuals, however, have a far different objective when we buy bonds, either as individual issues or through mutual funds. Mainly, we’re looking for a decent yield and some stability of principal. And we don’t want to have to turn around and sell in a few days.

A year ago, we could have all that and a lot more. In the January 2009 Utility Forecaster I featured a basket of eight bonds, all of which were investment-grade and had YTMs well above 8 percent. Moreover, their average maturity was less than five years, so there was virtually no inflation risk. And as no regulated utility has ever liquidated without paying bondholders, there was no real credit risk, either.

Today, however, those same bonds are throwing off YTMs of less than 4 percent on average. Some pay less than 3 percent. Investors who bought them in early 2009 are certainly sitting pretty. Not only have they locked in very high and safe yields for several years, but they’ve also realized some stunning capital gains as well, as these bonds’ prices have risen.

On the other hand, this would be an absolutely horrible time to buy them. It’s not that you would lose money. All are stronger credits than ever, and their near-term maturities will protect them from any inflation pressures. But you also won’t make more than the yield to maturity, which in some cases is now less than 3 percent.

Of course, there are bonds paying more now, mainly lower-rated or longer-dated fare. Reaching for that slightly extra yield means taking on a great deal of additional credit and inflation risk.

In my view, credit risk continues to diminish from the historic levels reached in late 2008. The US banking system is hardly a picture of health. But after a year of making repairs, the Federal Reserve is well aware of where the vulnerability lies, even as capital ratios gradually continue to improve. Bright spots are emerging in the economy, particularly the parts of it that trade with emerging Asia. Even unemployment seems to be stabilizing to some extent.

On the other hand, there are definitely major pockets of weakness out there. Commercial real estate remains a quagmire for anyone leveraged in it, as dividend cuts at virtually every US real estate investment trust over the past year demonstrate. Housing is still on its back. A large portion of the country’s industrial base is still idled and coming back on line at a sluggish rate at best.

The bottom line is the economy appears to be improving, but blowups of individual companies–even whole sectors–are still a grave risk. Even in wireless communications–where business is booming thanks to an explosion of smart phone and broadband applications–Sprint is still on the ropes, though it continues to promise better times ahead for the analysts still listening.

Sprint and others may escape a dire fate. And I remain optimistic about the US economy–which has eventually broken everyone who’s ever bet against it–over the long haul. But today’s pitifully low risk spreads hardly compensate anyone for the dangers that remain.

As for inflation, it’s hard to imagine a 1970s-style cycle of rising prices and interest rates without at least some improvement in the employment picture. On the other hand, a benchmark 10-year Treasury yield of less than 4 percent is hardly any compensation for what risk there is. And this economy does have challenges that in the past have always led to inflation.

The biggest of these is the quantitative easing that’s taken place since the economic crisis broke in earnest in mid-2008. That’s put a lot of dollars into circulation and extended US borrowing around the world to levels that could scarcely have been imagined a decade ago. Then there’s the “other people’s money” syndrome that seems to affect elected and appointed officials in all levels of government.

I remain convinced that we’re going to see a lot more appreciation in income-producing stocks before inflation will really become a problem. But I’m certainly not going to lock down money for 10 years at a YTM of barely 4 percent, a rate that doesn’t even compensate for a normal rate of inflation.

If there is good news here, it’s that those who a year ago locked in intermediate-term individual bonds issued by good companies are set to garner high and safe yields until they’re paid off at par value. There’s no reason to do anything but hold to maturity.

Those who own open-end bond funds also have little to worry about. These funds must make redemptions as well as accommodate new investment. As a result, their yields always match the market. And if you own a near- to intermediate-term fund, those yields will rise if and when inflation does become a risk. A sudden upward lurch in yield can hurt principal, but you’ll ultimately recover as the portfolio adjusts. Gains are never that exciting, and yields are low. But then again they rarely–if ever–lose money.

There is one group of bond investments, however, where investors are at considerable risk. That’s closed-end bond funds. Unlike open end funds, closed-end funds trade a fixed number of shares on major markets such as the New York Stock Exchange. Managers don’t have to meet redemptions or accommodate new investment, unless the funds issue or retire shares. As a result, they can stick with their portfolios and manage their yields.

To date, closed-end funds have avoided the yield crunch experienced by buyers of individual bonds or investors in open-end funds, simply because they’ve been able to stay out of the market. That’s changing, however, as a growing number of companies refinance existing bonds at lower rates.

Those redemptions have given the funds capital gains, many of which showed up in year-end distributions. But ultimately the dollars must be reinvested in either lower-yielding paper or in considerably riskier debt. If it’s the former, the only way to keep yields up is to leverage the fund with debt. If it’s the latter, more leverage may be avoided but portfolio risk increases.

Either way management is moving, closed-end fund investors are faced with falling yields, rising risk and, in most cases, both. Ironically, many of these funds are trading at their highest prices in years relative to net asset values (NAV), either as outright premiums to NAV or the smallest discounts in years. That’s because many investors see only high yields, paid either quarterly or monthly. And they’re willing to pay up for them on the faulty assumption that bonds are always safer than stocks.

As the carnage of late 2008 proved definitively, closed-end bond funds can be just as volatile as individual stocks. And from today’s prices, expectations have rarely been higher and by extension risks have rarely been greater.

There are a very rare few still worth holding. But it’s critical for every investor to take an inventory now of what their funds own in their portfolios, where the discount/premium stands in relation to historical averages and how much debt leverage managers are using.

Investors in the popular Templeton Global Income Fund (NYSE: GIM), for example, may be surprised to know the fund recently had considerable holdings in Russia and even Argentina. That doesn’t match up well against its current yield of barely 5 percent, or the fact that the fund now trades at a premium to NAV versus a discount of more than 10 percent a year ago.

Where should investors go if they sell closed-end bond funds and hold off on buying more individual bonds? My best advice remains to mix it up, with a focus on equities.

Forget the S&P 500 or conventional income portfolios. Build your own mix of high yielders, combining the best of the utilities, MLPs, high-yielding Canadian stocks and trusts, Super Oils and even select small banks and REITs. These have had a very good 12 months. But a fearful public is still pricing them well below where they were before the crisis. And the best continue to increase their dividends like clockwork, some quarterly.

The same rally that’s made bonds a poor place to put new money is making these equities better investments than ever by boosting balance sheets and underwriting future dividend growth. That’s where the best bets are, whether the rest of 2010 brings doom or more boom.

Question of the Week

We strive to answer every reader’s investment questions. Please send yours to

  • Some of my 1099s this year are showing some of my dividends as a return of capital. I didn’t sign up for this. Won’t this make my taxes more complicated? Does this mean my companies are liquidating? Aren’t I better off in something else?

As anyone who’s taken Accounting 101 knows, accounting is a language all its own. In fact, one of first things business schools teach in financial statement analysis (FSA) classes is not to obsess on any one number or group of numbers but to try to put them into context. The same numbers at one company may be telling an entirely different story at another, even one in its same industry. FSA is in large part about being a detective to discover what that context is, and the job is often highly complex.

Return of capital is one such area. If you own a unit trust like BP Prudhoe Bay Royalty Trust (NYSE: BPT), your shares–or units–basically represent a royalty stream on a fixed asset, in this case BP’s (NYSE: BP) Prudhoe Bay Field on the North Slope of Alaska. The royalty stream is based on the market value of the first 90,000 barrels of oil equivalent produced each day from that property.

No oil reserve is infinite. Although even BP doesn’t know exactly how many barrels are left at Prudhoe Bay, one thing is certain: The field is depleting and eventually will get to the point where the costs of getting the remaining barrels out will consume rather than produce cash flow. As a result, distributions paid to BPT unitholders are a 100 percent return of investment–or a “return of capital” (ROC)–until their initial investment is recovered.

In other words, if an investor buys BPT at $100 per unit, the first $100 per unit he or she receives in distributions is ROC. After that, what’s received is taxed as ordinary dividends. But until that first $100 is paid out, the investor owes no current taxes on BPT distributions. Rather, the distributions are deducted from the cost basis–the price initially paid for BPT–until that zeroes out. Should the investor then sell BPT, he or she would pay a capital gains tax on the sale price less that $100. As long as they hold BPT, that $100 will be untaxed.

Obviously, other businesses don’t deplete their assets the same way an oil royalty trust does. The investor tax accounting, however, works exactly the same way.

You’re right that it presents an additional wrinkle to doing your taxes. But today’s 1099s–and even the K-1s that must be filled out for your MLP holdings–pretty much spell out what’s necessary to file. All you really have to do is keep records.

Moreover, I don’t know about you, but I like being able to defer taxes. And ROC is about the only way to do legally while receiving current income. Advantages are particularly stark if you’re in a higher tax bracket. Not only do you defer taxes. But the eventual rate you pay is capital gains, which, even if the Obama administration raises it, will be a top rate of just 20 percent.

So why do businesses have ROC if they’re not depleting assets, as with an oil and gas producer? It all boils down to understanding the language of accounting as it applies to the company in question.

A corporation may experience a one-time charge that reduces reported earnings per share as required under Generally Accepted Accounting Principals (GAAP). But that charge may have no impact whatsoever on cash flow or real profitability, i.e. the company’s ability to pay dividends. Management continues to pay the same dividend. But because it didn’t earn it under GAAP rules, the payout is part or all return of capital or ROC.

In its purest sense, there was no real depletion of business value necessitating a return of the investor’s initial stake. In fact, such charges are often related to management moves that increase shareholder value. But for tax purposes, the dividend is ROC. Investors get a tax break and a more valuable company at the same time.

MLPs, of course, usually pay most or even all of their distributions as ROC. Here, too, however, the ROC has little or nothing to do with asset depletion, as these are almost universally growing businesses. Rather, MLPs are granted this tax advantage by the federal government in order to attract capital to finance construction and operation of assets that require large amounts of capital and are deemed vital to the national interest.

Enterprise Products Partners, for example, is hardly depleting as a business. In fact, it’s grown distributions for 22 consecutive quarters and continues to add valuable new assets that boost cash flow. But its distribution is loaded with ROC as a way to attract investors, lower its cost of capital and thereby boost unitholder value.

Sure, ROC adds a little complexity around tax time to the investment. But it also means paying lower taxes and getting a more valuable investment that builds wealth over time. Those few extra minutes spent dotting the I’s and crossing the T’s are time very well spent.

Race to the Summit

How best to ride this market? Join me and my colleagues GS Early, Elliott Gue, Yiannis Mostrous, and Benjamin Shepherd at the historic Hotel del Coronado for the 2010 Wealth Society Member Summit.

You’ll have the extraordinary opportunity to meet one-on-one with me, Elliott Gue, Yiannis Mostrous, Benjamin Shepherd and GS Early and ask anything you want about how to keep and grow your nest egg.

We’ll give it to you straight: the brightest trends and our best recommendations, and anything else you might want to know about how to profit in 2010 and beyond.

Space and time limit us to 100 participants, so mark the date on your calendar: April 23-24, 2010, in San Diego, where they say it’s 72 and sunny every day of the year. You may find all details at Better yet, call 1-800-832-2330 (between 9:00 a.m. and 5:00 p.m. EST Monday through Friday) or go online now to reserve your seat at the table.

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