April 19, 2014 Bond Lorde

Risk/Reward Vol. 217

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

"I know y'all think I'm lyin'
But listen you're wrong
Like I told you before
My word is bond."---lyrics "Word is Bond" sung by Ice T

"Then I began to fall so low
Lost all my friends/Had no where to go
Because nobody knows you
When you're down and out."---lyrics from "Nobody Knows You When You're Down and Out" sung by Eric Clapton

"We were in the hospital
Waiting for you to get well
In the ambulance you were laughing
The real fun was when we were young."---lyrics from "Hospital" sung by Lorde

As loyal readers know, I am an income investor. Because interest rates have been at historic lows since the financial crisis of 2008, my search for yield has forced me out of investment grade bonds and into riskier income securities such as master limited partnerships, real estate investment trusts, utlilites, preferred stocks, etc. But, "like I told you before", "my world is (still dictated by) bonds." With as many equity positions as I have, "I know y'all think I'm lying'"; "but listen you're wrong." Bonds, particularly the 10 Year U.S. Treasury Bond ("10Year"), influence, nay dominate, my every move. My thesis is this: understanding income producing stocks requires understanding bonds. Here is why. Backed by the full faith, credit and property of the United States, the 10Year is the security most analogous to the hypothetical risk-free asset upon which modern portfolio theory is based. All income securities are priced in relation (or "spread") to the return available on risk free assets; the greater the risk, the greater the spread that Mr. Market demands. Thus any movement in price/yield on the 10Year necessarily impacts all income securities. That's why I follow the bond market so assiduously. I even tolerate Rick Santelli's speaking voice (or rather his yelling). His insights on the bond market heard daily on CNBC are worth the screech and signal more about what to expect than any other commentary on that station. Also, it's why I read any and all columns written by Jon Hilsenrath of the Wall Street Journal ( free for non subscribers via Google one or two days after publication). His columns on bonds and interest rates are so influential, he refuses to Tweet, fearing the possible impact of an off-handed, unedited comment.

As loyal readers also know, central banks greatly influence bond prices (and thus their yields) by controlling short term interest rates, issuing forward guidance and purchasing bonds outright in programs such as the Federal Reserves's QE3. Less well known is the influence of two large bond fund sponsors, PIMCO and BlackRock, and the men who run them, Bill Gross and Larry Fink. If you look at the bond funds offered by your 401(k), chances are one or more are sponsored by PIMCO or BlackRock. Between them, these two sponsors control over $3Trillion worth of bonds, or over 3%% of the world's supply ($90TR). By comparison, despite having purchased $85billion of bonds per month for more than a year (QE3), the Federal Reserve today holds a total of $4Trillion in bonds, only 25% more than PIMCO and BlackRock. As you know, the spike in interest rates last year (after almost 30 years of falling rates) caused the price of bonds to plummet. (Remember, rising rates means falling prices.) Not surprisingly, "nobody fell so low" as Bill Gross who for the past decade has been known as the Bond King. Gross' reputation also suffered from orchestrating the departure of PIMCO's popular CEO, Mohamed El Erian. Indeed, recently it has been as if "Gross lost all his friends/and Had no where to go" But in my opinion, Gross' current diminished circumstance presents an excellent opportunity for income investors. It was precisely "Because nobody wanted to know Gross/When he was down and out" that I was able to purchase, at a discount to net asset value, shares of PFN, a closed end bond fund personally managed by Gross. PFN pays a 9+% annual dividend on a monthly basis and heretofore rarely if ever traded at a discount. In my opinion, buying PFN (and Gross' expertise) at a discount (still available, by the way) is like getting front row seats below face value to an Eric Clapton concert.

On the equity side, few sectors have outperformed real estate investment trusts (REIT's) this year. REIT's suffered from the spike in interest rates in 2013 because, as discussed above, they trade in relation to the 10Year. If interest rates increase as they did sharply last summer, prices fall. But REIT's have flourished in this year's surprisingly (to person's other than me, that is--see Vol. 186 http://www.riskrewardblog.blogspot.com ) stable rate environment . And in the REIT sector, health care REIT's have done particularly well. These entities own health care facilities which they rent via long term, triple net leases to hospitals, nursing home operators and physician groups. You may be of the opinion that "the real fun was when we were young", but the future for aging America is "in the ambulance" and/or "in the hospital waiting to get well". Consequently, I own HCN and HCP, both of which are up over 10% year to date. Since both now pay only a mid 5% dividend due to their run up in price, I do not see them appreciating in the next several months. For that reason, I recently purchased shares in HCT, a smaller health care REIT run by Nicholas Schorsch and William Kahane. They built ARCP into the largest commercial, triple net REIT in the country. I look for them to repeat that success in the health care arena, all the while maintaining a 7% dividend.

Thankfully, the markets rallied this holiday-shortened week. The Dow Jones Industrial Average closed up 382 points. And speaking of thanks, thank you all for your patience as I struggle to make sense of investing. Recording my thoughts and observations is helping me to formulate an investment philosophy. Moreover, I find your feedback to be invaluable. Clearly, I remain a novice, and under no circumstance would I, like Lorde, request that you "let me be your ruler, ruler." I do not wish to "live that fantasy." But I am convinced that the better we understand concepts such as relational asset pricing, the better investors we will be. We will no longer be merely "driving Cadillacs in our dreams." Instead, we will be enjoying:

"...Cristal, Maybach, diamonds on our timepiece
Jet planes, islands, and tigers on a gold leash."