February 8, 2014 For What It's Worth

Risk/Reward Vol. 207

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

"Carefree highway, let me slip away on you
Carefree highway, you see a better day."---lyrics from "Carefree Highway" sung by Gordon Lightfoot

"Spread your love/Let's spread our love together
Spread your love/I can feel it getting better."---lyrics from "Spread Your Love" sung by Earth, Wind and Fire

"Was I too far gone
Too far gone/Too far gone
For you?"---lyrics from "Too Far Gone" sung by Neil Young

Recently, I was asked why I obsess on the interest rate paid on the 10Year Treasury Bond. I attempted an explanation in Vol. 172 ( www.riskrewardblog.blogspot.com ), but in re-reading that edition I found it dense---barely intelligible in fact. Therefore, Dear Readers, allow me once again to attempt to explain this obsession. Modern portfolio theory rests in part upon the following principle as articulated by Warren Buffett: "The rates of return that investors need from an investment are directly tied to the risk free rate of return." Although the concept of "risk free" is as illusory as a "Carefree Highway", the asset universally recognized as the least risky in the world is the debt of the United States government. The denomination thereof most often used as the risk-free benchmark is the 10Year Treasury Bond. Thus before this concept "slips away on you", let's paraphrase Mr. Buffett: "all investments are directly tied to the interest rate of the10Year Treasury Bond." This principle is not difficult to grasp since no rational investor would make an investment involving risk without the prospect of a return greater than that afforded by the risk-free benchmark. Rational investors expect to be rewarded for the risk they take, and the more risk they assume the more reward they intend to reap.

This risk/reward scale is often expressed as the "spread" between the forecasted yield on the "risk-free"10Year Treasury Bond and the yield (dividend-interest plus capital appreciation) expected from the acquired asset. For example, since the 2008 financial crisis the spread between the expected return on the 10Year Treasury Bond and investment grade preferred stock has been 3.5%. So if in the foreseeable future, the 10Year is expected to yield 3.5%, then one would expect investment grade preferreds to be priced so as to yield 7% (3.5%+3.5%=7%). If the forecasted yield on the 10Year is 3% then one would expect a preferred stock to "spread its love together" and to be priced to yield 6.5%. As we all know, with bonds and bond-like assets (such as preferred stock) PRICES GO UP AS YIELDS GO DOWN. And when prices go up, "I can feel it getting better."

Last May after the Federal Reserve announced that it would taper its monthly purchases of Treasury Bonds (QE3) sometime in the then near-future, conventional wisdom was that the value of the 10Year Treasury Bond would decrease (since the Fed would no longer be bidding prices up) and that concomitantly the 10Year yield would go from a mid-May, 2013 rate of 2% to 3.5% or above as tapering progressed. Almost overnight, the price of the 10Year dropped precipitously to reflect the taper's anticipated impact. In turn, this move in the 10Year quickly was reflected in a steep drop in preferred stock and all other assets priced to produce a return tied or "spread" to the yield on the 10Year ( e.g. real estate investment trusts (REIT's), corporate bonds, junk bonds, senior notes, exchange traded debt---in other words everything income investors such as me like). I sold most of my spread-priced assets at that time. I watched the bond market closely over the next few months. By September I predicted that the yield on the 10Year would not exceed 3% even after tapering began, ( My rationale for so predicting can be found at Vol. 186 www.riskrewardblog.blogspot.com ). I also concluded that the market had "Gone too far/Gone too far for me" in pricing "spread" assets as if the10Year yield would rise to 3.5%. Accordingly, I re-invested heavily into preferred stock funds and REITS which I viewed as mis-priced. So far so good. The Dow Jones Industrial Average (DJIA) has dropped 4.72% year to date, but my portfolio has risen in value as the yield on the 10Year continues to hold around 2.7% even as the tapering of QE3 (which began last month) progresses. In sum, owning "spread" assets that were priced as if the 10Year interest rate were going to rise to 3.5% has been a good place to be recently as the market has become more comfortable with the prospect that the 10Year rate likely will stay at or below 3%, tapering notwithstanding. Recognizing this possibility is why I obsessed on the 10Year and continue to do so.

Another roller coaster ride was had on Wall Street as the DJIA started with a 326 point loss on Monday but ended up 96 points for the week. Here is my take on the situation, "For What It's Worth." (apologies to Neil Young and Buffalo Springfield) The markets are becoming range bound. If I am correct, anytime the indices try to break out either to the top or to the bottom, they will be "getting so much resistance from behind." It's as if "battle lines are being drawn." But, "stop children what's that sound?" It's a sigh of relief from those like me who are heavily invested in spread priced income securities. As explained above that's because "everybody look what's going down"---the current and forecasted yield on the benchmark 10Year Treasury Bond.