January 24, 2015 Droppin' Like Flies

Risk/Reward Vol. 251

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

“You're a three-decker sauerkraut
And toadstool sandwich,
With arsenic sauce!”---lyrics from “You’re A Mean One, Mr. Grinch” sung by Thurl Ravenscroft

“Oh, we're dropping; like flies.
Bye, bye.
You're droppin' like flies”---lyrics from “Droppin’ Like Flies” sung by Motley Crue

“And honey you should know
That I could never go on without you
Green eyes”---lyrics from “Green Eyes” sung by Coldplay

For the first time in a while, the most significant news of the week came from Europe. On Thursday, Mario Draghi the head of the European Central Bank (ECB) announced that the ECB is embarking on its own version of quantitative easing. The ECB will be purchasing 60billion Euros worth of public and private securities each month for a minimum of 20 months. The purpose of this campaign is to spur economic growth and to stave off deflation. Draghi wants to depress interest rates so that investors will be forced to invest in riskier assets, and consumers will be incentivized to purchase goods by accessing cheap debt. This ambitious move was done despite Germany’s opposition. In effect, the ECB is now Santa Claus for some weaker members of the Eurozone, handing them a blank check. But for Angela Merkel, the ECB is Mr. Grinch, serving her “a three-decker sauerkraut and toadstool sandwich with arsenic sauce.”

But how effective will Europe’s version of QE be in spurring economic growth? Apparently, Mr. Market thinks it will work. The Dow Jones Industrial Average rose 259 points or 1.48% and the S&P rose 31 points or 1.53% on the news that day (although they gave back half of those gains on Friday). I am not so sure. After all, the yields on the benchmark sovereign bonds of Europe’s largest economies have been “droppin’ like flies/ Bye bye/ droppin’ like flies” without QE. Even before the ECB’s announcement, the yield on the German Bund was 0.51%; on the French 10 year 0.72%; on the Italian 10 Year 1.71%; and on the Spanish 10 Year 1.55%. How much lower will they/can they go? That said, one benefit for me from the ECB’s move is that QE likely will keep the yield on the bellwether US Ten Year Treasury Bond in check. It finished the week at 1.82% (exactly where it was last Friday) despite a Wall Street Journal article authored by Federal Reserve insider Jon Hilsenrath reporting that the Fed was still on track to raise short term rates this year: this despite the ECB's contrary move and despite inflation running well below the Fed's target of 2%. All eyes and ears will be on the Fed meeting next week for any signal as to when a rate rise may occur.

So how do low yields on the 10Year benefit me? “Honey, you should know” by now. If the yield on the US Ten Year is held down, then the yields on the securities correlated to the 10Year (e.g. preferred stock, real estate investment trusts a/k/a REIT’s and municipal bonds) will likewise remain low and concomitantly their price/value will rise. (Remember, lower yields mean higher prices) (See the exhaustive discussion of correlation at Vol. 221 www.riskrewardblog.blogspot.com ). Indeed, “green” is what you see when you look at the year-to-date returns on the preferred stock closing table found at www.online.wsj.com/mdc/public/page/2_3024-Preferreds.html . I hold preferred stock in closed end funds which provide diversification and leverage at the same time. My favorite preferred closed end fund, FFC is up 9% so far in 2015 while paying an 8% dividend amortized monthly. My favorite REIT, Realty Income Corporation (O) is up 14% year to date while paying a 4.2% dividend amortized monthly. And my favorite municipal bond closed end fund MQT is up nearly 2.5% year to date while paying a tax advantaged dividend of over 6% amortized monthly.

I am comfortable with my portfolio, but it is interest rate sensitive. Thus I must be vigilant. With the ECB embarking upon an ambitious QE program, yields on longer term bonds, such as the US 10Year, should remain low even if the Federal Reserve raises rates at the shorter end. That said I have been unpleasantly surprised by sudden yield hikes in the past. When last that happened I felt like Coldplay:

“One minute I held the key

Next the walls were closed on me

And I discovered that my castles stand

Upon pillars of salt and pillars of sand”