(The opinions expressed here are those of the author, a columnist for Reuters.)
By John Wasik
CHICAGO, March 20 (Reuters) - For active income investors, the next year or so will be a trying time of tough love. While yields are rising, which depresses prices of most income-oriented securities, this presents other opportunities.
On Wednesday, Federal Reserve Chairman Janet Yellen signaled that interest rates may rise as early as next spring, and the market reacted with force, continuing a pullback that began nearly a year ago.
Some unheralded optimism lies behind Yellen’s comments that the Fed will end its bond-buying stimulus program this fall and probably raise short-term interest rates in the spring of 2015. That bodes well for a number of sectors which benefit from slowly rising rates and consumer spending.
Economic growth, low inflation and steady improvement in employment are pushing the Fed to wind down the central bank’s $3 trillion (total) program to buy Treasury securities and keep rates near zero - a monetary stimulus plan that’s been in force since the meltdown of 2008.
What makes sense for investors now? If you need income and aren’t locked into highly rated corporate, municipal or Treasury bonds that you hold to maturity, you’ll need vehicles that can adjust to rising rates without losing value.
For short-term cash, money-market mutual funds are flexible because they invest in short-term corporate and Treasury debt. Their net asset values are fixed at $1. Generally, any bond with maturities under two years will be least impacted by rising rates.
Rounding out your cash or short-term income portfolio should be specialized funds that can benefit from rising rates. The iShares Floating Rate Bond Exchange Traded Fund, for example, tracks an index of short-maturity investment-grade bonds that have adjustable rates.
The iShares fund, charging 0.20 percent for annual expenses, is up 0.5 percent for the year through March 19. That compares to a negative 0.3 percent return for the Barclays U.S. Aggregate Bond Total Return Index, a benchmark for the U.S. bond market, over the same period.
Another interest-rate tracking fund is the PowerShares Senior Loan Portfolio, which has gained 3 percent for the year through March 19. Following an index of senior loans issued to corporations and partnerships, the fund charges 0.65 percent annually for expenses.
Despite the cautionary tone of Yellen’s first statement as Fed chief, income markets got the yips after her pronouncements.
In the wake of Yellen’s press conference yesterday, prices on two-year Treasury notes fell to their lowest level since 2011. And it’s going to be bumpy for any yield-oriented investor in preferred stocks, real estate investment trusts, high-yield corporate bonds and most mid- to long-maturity bonds.
John Blank, chief equity strategist for Chicago-based Zacks Investment Research, predicts the yield on the 10-year Treasury note could reach 3.5 percent by December of this year, up from about 2.7 percent recently. That would be a game changer for active income investors.
“It’s been easy money for bonds for the past 30 years,” Blank said.
If the economic rebound in the U.S. continues, most of the potential upside will be in stocks, particularly companies in information technology, banks, consumer discretionary and cyclical industries, Blank predicts.
While U.S. home sales are still sluggish, likely due to a brutal winter, jobless claims are near a three-month low with employment slowly improving. If anything, Yellen’s comments were a nod to the growing evidence that the U.S. recovery is still on track.
Should the recovery continue apace, corporations will continue to invest in new equipment, consumers will have more money to spend and increased employment will buoy the economy at large. That means companies sitting on cash could be spending on technology.
The Vanguard Information Technology ETF tracks an index of the leading technology companies including Apple Inc , IBM and Cisco Systems Inc. The fund charges 0.14 percent for annual management expenses and has gained 28 percent for the year through March 19.
Consumers feeling flush will gravitate towards discretionary purchases, home spending, recreation and entertainment. The Consumer Discretionary Select Sector SPDR ETF follows an index that includes Comcast Corp, Amazon.com and Walt Disney Co. The fund is up 29 percent for the year through March 19 and charges 0.16 percent for annual expenses.
One of the largest beneficiaries of rising rates, though, will be banks, which can eventually raise their loan rates and profit margins. A worthy choice in that sector is the SPDR S&P Bank ETF, which tracks an index of leading regional banks. The fund is up 28 percent for the year through March 19. (Follow us @ReutersMoney or here Editing by Lauren Young)