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MarksJarvis: All eyes on interest rate

Amid concern over possible Fed action, more investors seek safety

Gail MarksJarvis

June 19, 2013

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The warnings have sounded.

In a dress rehearsal for the drama that might lie ahead in bonds and stocks, investors are discovering that some of the investments they thought would be fairly safe for income can deliver sudden losses. Popular dividend-paying investments such as utility stocks, real estate investment trusts (REITs) and master limited partnerships (MLPs) have dropped in value since early May.

That's not surprising to the pros, who realize that rising interest-rate environments can play havoc with dividend-paying investments. But it may be a shock for average investors who didn't understand previously the risks they'd be taking if the Federal Reserve started to hint at a new era for interest rates.

During the last couple of years, individuals turned to riskier investments such as utility stocks and MLPs when they became tired of earning virtually no interest in savings accounts, certificates of deposit and U.S. Treasury bonds and frantically started looking for alternatives.

The trouble is that when interest rates start rising from low levels, people dump the alternatives to bonds. And that's exactly what's been happening lately as yields on Treasury bonds have shot up swiftly.

The expectation is that Federal Reserve Chairman Ben Bernanke might say something Wednesday at the end of a scheduled meeting, or in the weeks ahead, that will boost yields on Treasury bonds even higher than the swift move that began in May and unnerved investors in both stocks and bonds.

Utilities had been a cozy investment until May. The SPDR utility exchange traded fund of utility stocks (XLU) had provided investors an unusually large 16.5 percent gain during the first four months of this year, but since early May investors have been selling the stocks. They have dropped 7.4 percent in value.

Anxiety over rising rates typically makes investors leery of utilities because some investors will decide the extra risk of owning a stock is not worth it when Treasury bonds eventually will pay them a decent interest rate.

While investors have shunned bonds at historically low rates the last couple of years, at some point Treasury bonds will be alluring to cautious investors as yields climb. Although yields on 10-year Treasurys were at 1.6 percent in early May and 2.2 percent recently, historically investors have averaged over 5 percent.

With a transition to attractive rates yet to happen, investors have been afraid of both stocks and bonds. They worry about buying bonds now because those bonds will be losers if rates rise. The iShares Trust Barclays 20+ Year Treasury Bond fund (TLT) has declined about 7.9 percent since early May. But analysts say stocks are risky now too because they've become expensive and investors are worried they will be vulnerable in a rising rate environment.

"It's a 'buyer beware' market now," asset allocation strategist Anne Lester, of J.P. Morgan's Global Multi-Asset Group, said last week at Morningstar's annual conference.

During the three-day Morningstar investment conference, as top mutual fund managers talked about concerns in both the stock and bond markets, Morningstar analyst Scott Burns joked that the negative outlooks would prompt a rise in "mattress sales."

In the investment field, pros talk about mattresses when they see dicey conditions in the stock market and suggest that storing some money temporarily for safekeeping might make sense. They don't mean storing money under mattresses literally. Rather, money market funds or stable value funds can be the choice.

Individual investors have been doing just that during the last two weeks. They have put about $20 billion into money market funds despite the fact that the funds pay virtually no interest.

James Montier, of GMO's Asset Allocation team, told the Morningstar audience that the current investing environment "is really challenging," with both stocks and bonds "priced for perfection." Although he realizes investors won't make any money by parking cash, it will protect them if there is a fierce downturn and give them a chance to buy stocks if they plunge.

"Cash is dry powder, a store of value," he said. Showing far more caution than most fund managers, Montier says his core fund has about 45 percent of its money stored in cash.

Oakmark fund manager Bill Nygren doesn't think the stock market is pricey, but he said, "I am frustrated that dividend seekers have bid up the price" on many stocks that pay dividends. He sees particular risk in utility and food company stocks because cautious investors have moved so much money into those stocks as they have desperately sought income. He thinks prices could plunge as individuals sell the stocks and move into bonds at a later point.

The question on investors' minds is when that point will arrive. James Keenan, who heads leveraged financial portfolios within BlackRock's fixed-income group, is not expecting yields to move much higher than they've already moved this year, although he thinks they will get to 3 percent within 18 months.

Analysts expect Bernanke to try to calm investors, realizing that rates climbed sharply after he suggested May 22 that at some point the Federal Reserve will start tapering off the bond purchases known as quantitative easing. By buying bonds the Fed has tried to keep mortgage and other loan rates low so that individuals and businesses would make major purchases and stimulate growth in the economy.

While the housing market has improved, individuals still are having difficulty getting loans and the unemployment rate, at 7.6 percent, is far above the 6.5 percent Bernanke has said he wants to see before ending stimulus.

gmarksjarvis@tribune.com

Twitter @gailmarksjarvis