Weekly Market Commentary - Add More Bond - James Bond - to Your Portfolio
50 years ago, in the James Bond movie Goldfinger, an alternative to the traditional car helped Bond out of some risky situations. 50 years later, bonds are facing a risky situation — and alternatives to traditional investments may help to capitalize on it. Add More Bond - James Bond - to Your Portfolio
It was 1964, 50 years ago, that the film Goldfinger debuted. It is the quintessential James Bond film and the first one to win an Academy Award. In Goldfinger, Q — the head of the gadget-making “Q-Branch” — presents Bond an alternative to the traditional car. It can emit an oil slick and has a battering ram, a pop-up rear bulletproof screen, and even an ejector seat. These gadgets helped Bond make the best of some risky situations. Now, 50 years later, bonds are facing a risky situation — and alternative investments may help to make the best of it.
Although not part of the overall bond market measured by the Barclays Capital Aggregate Bond Index, the high-yield and municipal bonds we favor for 2014 are considered traditional investments. As your “Q-Branch,” LPL Financial Research would like to present you with some alternatives to traditional investments that may be helpful in 2014 as faster growth may lead to higher interest rates and flat returns for the bond market: bank loans, business development companies (BDCs), real estate investment trusts (REITs), and master limited partnerships (MLPs).
* Bank loans. Bank loans are an alternative that seeks to offer an attractive yield and less interest rate risk for 2014. The interest rates on these loans made to businesses float higher with short-term interest rates. While bank loans can suffer losses when economic growth deteriorates and negatively impacts the ability of companies to repay their borrowings, we expect solid economic growth in 2014. Finally, they behaved well in last year’s interest rate run-up from May to July, as you can see in Figure 2.
* BDCs. Business development companies function like banks by lending money to businesses. BDCs have flexibility to go beyond the most senior structured loans, so they can have more credit risk if the economy deteriorates, resulting in companies being unable to repay their debts. Illustrating this heightened leverage and credit exposure, the Wells Fargo BDC Index has behaved like 2.25 times the Barclays Capital High Yield Bond Index, as you can see in Figure 3. It is a good idea to keep the 2.25 factor in mind when considering weighting and overall portfolio credit exposure.
* REITs. Looking back over the past 20 years, REITs (measured by the NAREIT Index) have generally provided solid yields and strong total returns with the exception of poor relative returns in 1998 – 99, 2007 – 08, and 2013. In 2013, REIT returns were similar in magnitude to 2002 and 1994, when they outperformed stocks and bonds, but in 2013 the S&P 500 Index outperformed REITs by a margin of about 30 percentage points.In 2007 – 08, credit conditions and the bursting of a real estate bubble were the problems contributing to REIT losses — something we do not expect to see in 2014. However, in 1998 – 99 and in 2013, we saw rising interest rates and a move by the Federal Reserve to become less bond market friendly. We expect that to be the case in 2014 as well. In 2013, interest rates went up in the late spring and early summer without being accompanied by better economic growth and that led to poor returns for REITs and remains a risk for 2014. However, in 2014 we expect better growth to accompany the rise in rates — making a better environment for REITs as occupancy and rents rise. From a valuation perspective, REITs are fairly valued on historical metrics like discount to net asset value, price to funds from operations, and spreads to BBB bonds. While they may fare better in 2014 than in 2013, REITs still face headwinds from rising interest rates, making REITs likely to underperform stocks, but outperform bonds.
* MLPs. In comparison to REITs, rising U.S. liquid fuel transportation needs may make MLPs that operate pipelines able to re-price rents and keep up with rising rates in 2014. A key beneficiary of the American energy renaissance, pipelines are seeing strong volume growth. In 2013, MLPs provided solid mid-single digit yields and posted double-digit total returns that nearly kept up with the soaring stock market (the Alerian MLP Index produced a total return of 27.6% in 2013, less than 5% below the 32.4% for the S&P 500). The U.S. Energy Information Agency forecasts transportation of U.S. crude oil production will continue to grow in 2014 near last year’s growth rate of 16%. Rising transportation demand may help to support another year of solid performance for MLPs in 2014 despite the risk posed by higher interest rates and some degree of commodity price sensitivity.
The alternative features installed in his car that helped to make Bond safer were not safety equipment. But used in the right way, they did help to protect him and provided an advantage when facing certain risky situations. The alternative investments featured here are not safer investments. But, used the right way, they may provide some protection from the risks and the potential to capitalize on the opportunities we believe investors face in 2014.